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Markets have been craving information about how the Federal Reserve plans to shrink its massive $9 trillion balance sheet. They will get their wish Wednesday when the Fed releases minutes of its March meeting.
Last month, Fed Chair Jerome Powell said the central bank made “excellent progress” on the balance sheet and the parameters would come with the minutes.
“We’ll get some information tomorrow, hopefully enough to satisfy the market,” said Kathy Bostjancic, director of U.S. macro investor services at Oxford Economics.
She said she was worried the market was expecting too much.
“They will give us the basic plan, whether they give us the specifics, I’m kind of doubtful,” she said.
The Fed’s balance sheet doubled in size during the pandemic to $9 trillion as the central bank bought trillions of Treasurys and mortgage-backed securities, first to come to the rescue of a faltering U.S. bond market and later to help the economy recover.
Under the Fed’s thinking, the large balance sheet is pushing down long-term rates – stimulating the economy. That’s no longer appropriate with inflation running at its highest rate in 40 years.
The impact of the shrinking of the balance sheet – called quantitative tightening by some – is not well understood.
“There is no way anyone has an extraordinary clear view as to what the unwind of the balance sheet — especially as large as it is now — is going to do to financial markets and the economy,” said Seth Carpenter, global chief economist at Morgan Stanley, at a recent NABE conference.
Markets and the Fed are a bit on edge about the process of shrinking the balance sheet.
On Tuesday, the yield on the 10-year Treasury note
TMUBMUSD10Y,
jumped after Fed Governor Lael Brainard said the Fed would shrink its balance sheet at a “rapid” pace. Stocks fell, with rate-sensitive tech-related shares leading the way lower as the Nasdaq Composite
COMP,
slumped by more than 2%, while the S&P 500
SPX,
fell more than 1% and the Dow Jones Industrial Average
DJIA,
shed 0.6%.
The Fed has only shrunk its balance sheet once before — from 2017 – 2019. It went well, until it didn’t.
Starting in October 2017, the Fed was able to shrink its balance sheet from $4.2 trillion to $3.6 trillion. But in September 2019, volatility in the money markets forced the Fed to quickly stop shrinking its balance sheet and purchase Treasurys to add liquidity to the banking system.
The Fed hopes this time is different. To guard against volatility, the Fed has set up a facility where banks can come to the central bank for emergency reserves.
For now, the Fed doesn’t plan to sell any securities on its balance sheet.
Instead, the Fed allows maturing securities to roll off the balance sheet and doesn’t reinvest the proceeds.
Philadelphia Fed President Patrick Harker has said he wants the balance sheet roll off to be so boring that it is like “watching paint dry.” The goals is to set it and forget it.
To keep the process orderly, the Fed set monthly “caps” on how many securities can roll off.
That’s almost twice as much as the $50 billion per month pace of quantitative tightening in 2017-2019.
Wall Street thinks the Fed will eventually allow $80 billion-$90 billion to roll off monthly after a slower start — so perhaps $50 billion of Treasurys and $30 billion of mortgage debt.
One difference this time is that the Fed has T-bills on its balance sheet.
Economists generally expect the Fed to aim to reduce its balance sheet by $3 trillion over three years.
This is a big adjustment for markets. By the middle of 2025, private investors will have to hold $3 trillion of Treasurys and mortgages.
The Treasury Department also has a role in the process. With the Fed no longer buying debt, Treasury will have to decide where along the yield curve to issue the debt.
The mortgage market is losing a large price-insensitive buyer.
The minutes aren’t expected to announce the start date for the runoff. Analysts think there is a good chance that will be announced after the next Fed meeting on May 3-4.
The minutes also may provide clues on what would push the Fed to raise its benchmark rate by 50 basis points in May.
Since the March meeting, many Fed officials have said a half-point hike will be “on the table” at the May meeting. Some economists were worried that starting quantitative tightening along with a 50 basis point rate hike would be too aggressive.
“The minutes probably won’t resolve the question of how large the May rate hike will be, but only because the committee itself is not yet sure,” said Lou Crandall, chief economist at Wrightson/ICAP, in a note to clients.
