As the economy gains momentum, a more prolonged, yet gradual pace of rate hikes seems to be on the cards. As a result of the improvement in the economy, the Fed already increased the target range for the federal funds rate by 25bp to 0.75-1% at its March meeting and continues to expect two additional rate hikes later this year, followed by a further three next year. As interest rates return to more normal levels, the next step for the Fed is to reduce the size of its balance sheet. Although policymakers intend to shrink the balance sheet in a predictable manner, questions are now being raised about the applicable conditions and timing. This report analyses the options available to the Federal Open Market Committee (FOMC) and the possible implications of balance sheet normalisation.170410-Fed-balance-sheet-policy-1.pdf (609 KB)
Fed’s balance sheet: where are we now?
From 2009 to 2014, the expansion of the Fed’s balance sheet was driven by a series of large-scale asset purchase programmes that were conducted to support the housing market and improve credit conditions more widely. The Fed mainly purchased Treasuries and mortgage-backed securities (MBS).
The Fed’s balance sheet now amounts to around USD 4.5 trillion dollars. In order to maintain an accommodative monetary policy, the Fed has reinvested principal payments from its holdings of US Treasury securities (USD 2.5 trillion) and mortgaged-backed securities (USD 1.8 trillion), as well as rolling over maturing Treasuries since net asset purchases ended in 2014. As a result, the total liabilities in the balance sheet has remained broadly unchanged since the end of quantitative easing. The current balance sheet differs from the pre-recession balance sheet in size and composition. Pre-crisis the balance sheet totalled around USD 1 trillion. On the asset side most of the assets were Treasuries. On the liabilities side, the main components was currency in circulation. Since the global financial crisis reserves have been increasingly dominant (rising from a share of 1.3% to 53%), while demand for currency and reverse repos has also increased.
Plans for normalisation
The FOMC published its principles and plans for normalisation back in 2014, with rate hikes comprising the first step. The Fed can continue using the interest rate on excess reserves (IOER) to target a federal funds rate, as an active policy tool of policy. As well as the Fed having more experience with this interest rate policy, it is also much simpler to communicate. However, as the process advances, the Committee has said that, in the longer run, it will hold no more securities than are necessary to implement monetary policy efficiently and will instead primarily hold Treasury securities.
Options for shrinking the balance sheet
As soon as the Fed is confident about the economic trajectory and regards the risks as balanced, it is likely to start normalising the balance sheet. The quickest way to shrink the balance sheet would be to stop reinvestments and to actively sell assets all at once, with the aim of achieving a specific balance sheet size within a certain period. We think the FOMC is unlikely to choose this option, given it could unsettle financial markets. Moreover, the FOMC is traditionally cautious about engaging in monetary policy tightening. At the other extreme is the option for the FOMC to let securities mature “passively” by ending or reducing reinvestment. This is a more predictable way of shrinking the balance sheet. Given that this option will take several years to complete, the FOMC will have the option to reinvest, if needed. This “in between” option will allow the FOMC more freedom to influence monetary policy and thus achieve a better combination of interest and balance sheet policies. For instance, this could mean phasing out mortgage reinvestments, but maintaining some level of Treasury reinvestment.
FOMC discussions on balance sheet normalisation
According to the March FOMC minutes, policymakers have been discussing possible change in the reinvestment policy. Although no decisions have yet been taken the discussions will continue at subsequent meetings. From the minutes we judge that participants generally preferred to phase out reinvestments of Treasury Securities and agency MBS. This was seen as an option that would reduce the risks of misleading signals that could trigger financial market volatility. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing a swifter normalisation of the size of the balance sheet. Moreover, the proposal to promote rapid normalisation, setting a minimum pace for reductions in MBS holdings and when necessary to sell MBS to maintain such a pace was also considered, but had so far limited support.
Timeline for balance sheet normalisation
Going forward, the Fed’s view on economic conditions, the inflation outlook and the strength of the US dollar will all be critical in setting the stage for the timing and pace of balance sheet normalisation. The risks of inflation accelerating too rapidly, for instance, could force the Fed to start shrinking the balance sheet earlier than otherwise. Meanwhile, a too strong US dollar, which could counterbalance the upside of inflation risks, could prompt the Fed to delay the process. Another factor to consider is the maturity schedule of the securities currently in the balance sheet. The following graphs show that maturities are concentrated in 2018 and 2019. Overall, public discussions of several Fed officials, suggest that there are different views on the timing of any action to reduce the central bank’s balance sheet. Most favour a time when there is no risk that the process will be reversed. March’s FOMC minutes indicated that policymakers judged that a change in the Committee’s reinvestment policy would likely be appropriate later this year.
Balance sheet size
In determining the appropriate size of the balance sheet, the FOMC could refer to the size before the global financial crisis. At that time, money in circulation amounted to around USD 760 billion and there were hardly any reserves. Currently, currency in circulation amounts to USD 1.5 trillion. The Fed has estimated that the size of the balance sheet is expected to be USD 2.5 trillion over a decade, reflecting the changes in nominal GDP growth and the assumed changes in currency outstanding . That would probably be the minimum size of the balance sheet. However, the Fed also has to consider the appropriate level of reserves for banks to hold for financial stability purposes and to ensure efficient functioning of the payments system. In our scenario, the FOMC will not reach a balance sheet size similar to its pre-crisis levels until after 2022 if it ceases reinvesting Treasuries and MBS starting this year.
Interest rate policy during normalisation
Since December 2015, the Fed has on three occasions raised rates. The Fed uses the IOER rate, together with overnight reverse repurchase agreement facility to raise the effective federal funds rate within this range (please see graph below). Asset sales by the FOMC will reduce liabilities, implying that banks will experience a drop in reserves. However, excess liquidity will remain in the system in the coming years, meaning that the IOER and the reverse repo rate will remain the instruments to control the federal funds rate for the foreseeable future.
Impact on financial conditions
Given a gradual reduction in the balance sheet, we would expect the impact on markets and financial conditions to remain moderate. Moreover, the limited response of markets to the potential changes in the reinvestment strategy discussed during the FOMC meeting, suggests that this gradual process is already priced in. However, further rate hikes and improving economic conditions will likely put some pressure on yields, but this will be moderate. As for MBS, somewhat higher yields could impact the housing market, which has seen a slow recovery. Given the Fed’s MBS holdings (around USD 1.8 trillion), the impact on yields could then be substantial if the option were to sell MBS all at once, but this is unlikely. Although the housing market has admittedly shown some improvement, the Fed still holds substantial amounts of MBS, representing around a fifth of the total US MBS market. It is also important to note that although Treasuries mature at predictable rates, the maturity of MBS are less predictable as they also depend on the rate at which the mortgages backing the securities are refinanced and on mortgage defaults.
It is still unclear whether the FOMC will opt to phase out reinvestment or end it all at once. We do not think the Fed needs to rush, given that it still has the option of increasing rates. However, given that the economy is gaining momentum and that fiscal stimulus could materialise in 2018, we think that announcements on the strategy will likely be communicated this year. To begin, the timing for the kick-off could be tied to an appropriate level of the target range of the federal funds rate. Given that the Fed looks at the economic conditions and the balance of risks to raise rates, once the rates have reached a certain level, for instance one that leads to an IOER of 1.5%, then this could be the trigger. In our view we think that by the end of the year, the FOMC’s communication would likely focus on an appropriate size of the Fed’s balance sheet, around USD 2.5 trillion over 10 years, according to the Fed’s estimates and the appropriate pace.
We think that a phasing out strategy would be smoother and would have the least impact on yields. This could mean phasing out mortgage reinvestments, but maintaining some level of Treasuries reinvestments. This combination would amount to reducing the Treasury and mortgage portfolios by about USD 300 bn per year in the initial years. A phasing out strategy as proposed, in any case would only allow the Fed to reach a balance sheet as proposed above only after 2022. The major risks in the process of shrinking the balance sheet are the communications and predictability of the path towards normalisation. We don’t expect that stopping reinvesting will lead to a large rise in yields if the process is well communicated, and gradually phased out, rather than stopped all at once.
 Board of Governors of the Federal Reserve, Confidence Interval Projections of the Federal Reserve Balance Sheet and Income, January 2017