Having bought unprecedented quantities of bonds in an attempt to keep the economy going after the global financial crisis, the U.S. Federal Reserve (Fed) is considering reducing its mammoth balance sheet. Over the past decade, this has grown from $900 billion to $4.2 trillion, essentially because of the central bank’s quantitative easing (QE) program.
Such a reduction is no small task and raises several important questions.
Why is the Fed talking about reducing the size of its balance sheet now? This is really about trying to ensure the Fed is able to respond to future crises. A smaller balance sheet would give the Fed more scope to expand it again to fight any future downturn.
Furthermore, the sheer amount of bonds held by the Fed is restricting supply in the wider market, which is keeping prices high and suppressing long-term yields. This could lead to bubbles forming in certain asset classes as investors look for yield from other, more risky sources.
When might the Fed begin reducing its balance sheet? The Fed has suggested that they might start this year if the economy keeps performing as it has been. On this basis, we think that they will begin reducing the size of its balance sheet in December.
There is a risk that the balance sheet reduction could cause the economy to turn, as the increase in supply of bonds causes yields to spike. But the Fed should be able to raise its funds rate twice between now and the start of the process. This would give the Fed some breathing space to cut rates if the balance sheet reduction does cause an abrupt tightening in financial conditions.
Chair Janet Yellen’s term is up in February 2018 and it’s unclear whether she will stay on. It will be a delicate time for financial markets, so starting the balance sheet process at the end of the year also avoids overlap with any potential Fed leadership transition.
How will the Fed reduce the size of its balance sheet? The Fed’s most recent formal guidance on balance sheet reduction—a September 2014 statement on “Policy Normalization Principles and Plans”—outlines an intention “to reduce the Federal Reserve's securities holdings…primarily by ceasing to reinvest repayments of principal,” rather than by outright asset sales. In other words, the Fed wouldn’t actually sell current holdings, but would simply stop buying any more once its current bonds mature.
Fed officials appear to believe, and we agree, that allowing maturing assets to roll off the balance sheet passively is likely to minimize potential market disruption.
At what pace might the Fed allow maturing assets to run off? The Fed has not made its thinking clear yet. Our assessment of the Fed’s balance sheet indicates that $550 billion of assets will mature in 2018, $450 billion in 2019 and $350 billion in 2020. Letting those assets run off amounts to a fairly substantial pace: $550 billion is 13 percent of the total balance sheet.