Fed Balance Sheet Normalization

May 25, 2017 | ,

The Federal Reserve recently increased its commentary on how and when to reduce its $4.5 trillion balance sheet, comprised of $2.5 trillion in Treasury bonds and $2 trillion in mortgage-backed securities (MBS). Shown in this week’s chart, that amount grew at a rapid rate from under $1 trillion during the 2008 financial crisis to where it is today. This growth was the result of unprecedented monetary stimulus in the form of large-scale bond-buying to keep the economy afloat by flooding it with cash through the Great Recession.

Recent commentary suggests that the Fed might gradually normalize its balance sheet later this year at an expected rate of $1.5 trillion spread over five years. The minutes released this Wednesday from the latest Federal Open Market Committee meeting show even more clarity on this process: The Fed intends to pre-announce, on a regular basis, caps on the amounts of bonds that it would allow to mature without reinvesting. It would start at very low caps and would then raise these caps on a quarterly basis, depending on how strongly the economy continues to grow. The minutes stated, “Nearly all policymakers expressed a favorable view of this general approach.”

Gradually reducing the Fed’s balance sheet may have a similar effect as hiking rates, which the Fed is expected to continue to do. It may ultimately increase Treasury and MBS yields and put downward pressure on their prices as the Fed reduces its role as a buyer. The market is expected to counter this effect, however, as international demand for Treasury bonds remain strong given the continued low and negative rates in countries such as Germany and Japan. Moreover, the market was able to absorb about $5 trillion of MBS during the housing boom, and is expected to absorb much of the MBS that is not retained in by the Fed. The ultimate effect on interest rates from these two opposing forces is unknown, but at the least they should mostly offset to prevent a rapid increase in interest rates.

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