After months of debate, the Federal Reserve has a plan to reduce its $9 trillion balance sheet as it tries to tighten monetary policy and tackle the highest inflation in decades.
Details of the plan were included in the minutes of the last policy meeting in March, when the Federal Open Market Committee implemented the first interest rate increase since 2018 and signaled its intention to continue raising it to a “neutral” level that does not drive nor does it stop growth.
In addition to interest rate hikes, the balance sheet reduction is the second pillar of the Fed’s plan to reduce the huge injection of monetary stimulus injected into the economy at the start of the pandemic.
“It’s hard to look at the balance sheet plan that the FOMC released and get the impression that they’re not serious about removing dovish policy,” said Robert Rosener, senior US economist at Morgan Stanley.
Here’s what the Fed has proposed and why financial markets are nervous:
How will the Federal Reserve reduce the balance?
Officials widely agree that the Fed should shed up to $95 billion of assets a month from the central bank’s huge balance sheet and build up to that level for about three months beginning in May.
The Fed will seek to “retire” $60 billion of Treasury bonds each month by not reinvesting proceeds from maturing bonds. When the amount of Treasury bonds maturing falls short of that level, the central bank has suggested making up the difference by reducing its holdings of shorter-dated Treasury bills, worth about $325 billion.
The Fed also wants to reduce its holdings of agency mortgage-backed securities, which it began buying during the pandemic, capping the drawdown on this asset class at $35 billion per month. However, economists say it may fall short of this target given the timing of when securities are expected to mature.
Stephen Stanley, an economist at Amherst Pierpont, estimates that the MBS agency’s holdings will decline by just $25 billion per month. Fed policymakers have said they would consider selling some of the reserves outright, rather than wait for the securities to be removed from the balance sheet, but this will only happen when the pruning process is “well advanced.”
How aggressive is the Fed’s plan?
Rising inflation coupled with one of the tightest labor markets in history has led the Fed to plan a balance sheet reduction that would be much faster than the last time it tried to reduce its holdings.
After vacuuming bonds in the wake of the 2008 financial crisis, the Fed waited until 2015 to raise rates and then two more years before reducing its balance sheet. Then it took the Fed about another year to raise the asset reduction limit to $50 billion a month.
Lael Brainard, a Fed governor who is about to become vice chair, said this week that a higher quick peace this time is justified “since the recovery has been considerably stronger and faster than in the previous cycle.”
The Fed has taken a similar approach to raising interest rates, with many officials now support half-point interest rate increases at one or more meetings this year, the first time such an increase will be used since 2000. Wall Street is bracing for multiple half-point adjustments, the first in May.
“By gradually increasing the rhetoric, [the Fed has] it allowed markets to recalibrate to this new monetary regime without excessively tightening financial conditions,” said Diana Amoa, chief investment officer at Kirkoswald, a hedge fund.
How have the financial markets reacted?
The beginning of the end of the Fed’s pandemic-era stimulus has hit every corner of financial markets. The record rally in US stocks and the boom in the housing market were underpinned by low borrowing costs ushered in by the Fed’s ultra-loose monetary policy.
Borrowing costs have risen since early March as the market anticipated higher interest rates, sending mortgage rates soaring and stocks plunging from record highs. A smaller Fed balance sheet could accelerate those trends.
As the Federal Reserve pulls out, the supply of Treasuries available to investors will soar, pushing US government bond yields, which hit three-year highs on Wednesday, even higher. .
Will there be liquidity problems?
The rush of supply could also have an impact on liquidity (the ease with which traders can buy or sell) in the Treasury market, which has deteriorated to the lowest level. worst level since the start of the pandemic.
“This is a large amount of Treasury collateral for the market to absorb in an environment where there is elevated volatility and a lot of uncertainty,” said Mark Cabana, head of US rates strategy at Bank of America.
chaos ensued the last time the Fed tried to reduce its balance sheet. In 2019, short-term funding rates spiked, suggesting the central bank had withdrawn too far from the market. Still, the Fed hopes it can avoid a repeat of that specific liquidity problem, after it last year set up a permanent facility that allows eligible investors to redeem Treasury bills for cash.