After months of wrangling, the US Federal Reserve has a plan to shrink its $9 trillion balance sheet as it tries to tighten monetary policy and tackle the highest rate of inflation in decades.
Details of the plan were included in minutes from the last policy meeting in March when the FOMC implemented its first rate hike since 2018, and indicated its intention to continue raising it to a “neutral” level that neither accelerates nor slows growth.
Along with higher interest rates, balance sheet shrinkage is the second pillar of the Fed’s plan to curtail the massive injection of monetary stimulus that was injected into the economy at the start of the pandemic.
“It’s hard to look at the FOMC’s balance sheet plan and get the impression that they aren’t serious regarding removing consensus,” said Robert Rosner, chief US economist at Morgan Stanley.
Here’s what the Federal Reserve suggested and why financial markets are on edge:
How will the Fed shrink the balance sheet?
Officials generally agree that the Fed should dump $95 billion in assets a month from the central bank’s massive balance sheet, and raise that level over regarding three months starting in May.
The Federal Reserve will seek to “roll out” $60 billion in Treasuries each month by not reinvesting maturing bond proceeds. When the amount of Treasury bonds due falls below this level, the central bank suggested compensating the difference by reducing its holdings of short-term Treasury bonds, of which it owns regarding $325 billion.
The Fed also wants to reduce its holdings of MBS-backed securities, which it began buying during the pandemic, limiting this asset class to $35 billion a month. However, economists say this may not achieve the target given when the securities are expected to become due.
Stephen Stanley, an economist at Amherst Pierpont, estimates that mortgage-backed securities holdings will fall just $25 billion a month. Fed policymakers have said they will consider selling some inventory outright, rather than waiting for the securities to be rolled off the balance sheet, but that will only happen when the downsizing is “in full swing”.
How serious is the Fed’s plan?
Soaring inflation along with one of the narrowest labor markets in history has the Fed planning to cut its balance sheet and it will be much faster than the last time it tried to cut its holdings.
After collecting bonds in the wake of the 2008 financial crisis, the Fed waited until 2015 to raise interest rates and then another two years or so before shrinking its balance sheet. Then it took the Fed regarding another year to raise the cap on asset reductions to $50 billion a month.
Lyle Brainard, the Fed governor who is poised to become vice president, said this week that the fast pace was justified this time “given that the recovery was a lot stronger and faster than it was in the previous phase”.
The Fed has taken a similar approach to raising rates, with many officials now supporting a half-point rate hike at one or more meetings this year — the first time such a hike has been used since 2000. Wall Street is preparing for multiple half-point adjustments, The first adjustments will come in May.
“By gradually ramping up the rhetoric, the Fed allowed markets to recalibrate the new monetary system without excessively tightening financial conditions,” said Diana Amoa, chief investment officer at Kirkoswald, a hedge fund.
How did the financial markets react?
The beginning of the end of the Fed’s pandemic-era stimulus has affected every corner of financial markets. The record rise in US stocks and the housing boom was built on low borrowing costs that started with the very loose monetary policy of the Federal Reserve.
Borrowing costs have jumped since early March as the market expected interest rates to rise, driving up mortgage rates and plunging stocks from all-time highs. A smaller Federal Reserve budget might accelerate these trends.
With the Fed retreating, the supply of Treasuries available to investors will swell, pushing US government bond yields – which rose on Wednesday to a three-year high – higher.
Will there be liquidity problems?
The flow of supply might also have an impact on liquidity – the ease with which traders can buy or sell – in the Treasury market, which has plummeted to the worst level since the pandemic began.
“This is a great guarantee for Treasury to accommodate the market in an environment of high volatility and a lot of uncertainty,” said Mark Cabana, head of US interest rate strategy at Bank of America.
Chaos arose the last time the Fed tried to shrink its balance sheet. In 2019, short-term financing rates rose, indicating that the central bank has withdrawn large sums from the market. However, the Fed hopes it can avoid returning this particular liquidity problem, having created a permanent facility last year that allows qualified investors to swap Treasuries for cash.
Menu
