How Will the Federal Reserve Reduce Its Balance Sheet?

The Federal Reserve (“Fed”) is now tightening monetary policy in the U.S. Interest rates are moving up slowly. And concomitantly Fed’s focus is to address its USD4.5 trillion balance sheet.

In late 2008, the Fed began large scale purchases of assets – U.S. Treasuries (USD2.5 trillion) and government-supported mortgage backed securities (“MBS”) of USD1.8 trillion to inject liquidity into the system and prevent a collapse of the U.S. financial system. For six years, it was quantitative easing (“QE”) – which kept interest rates low while equities and corporate profits up. The idea was to spur growth. The U.S. financial system thereby survived.

On October 29, 2014 the then Fed Chairperson, Janet Yellen, announced the end of the bond-buying program. Fed’s plan to reduce balance sheet is through one of two ways – sell securities on its balance sheet or choose not to reinvest in maturing securities. The first step would put pressure on the bond market and cause interest rates to rise rapidly and we will have more volatility. By simply allowing balance sheet to decline slowly by not reinvesting in maturing assets is the second and more mature approach – about USD1.4 trillion of the USD2.5 trillion Treasuries have maturities of less than five years.

So what’s the final balance sheet size? The magic number is to be determined once the balance sheet drops to below USD3 trillion in 2020.

So what’s the consequence? Balance sheet reduction and interest rate rise will impact negatively on economic growth (a slowdown not negative growth) and the equities market world-wide.

By how much? That is a difficult question to answer!

Reference:  Various articles, including by Aaron Hankin (September 20, 2017)