How to shrink the $8 trillion balance sheet? Wall Street debates Fed roadmap

Fed officials initially discussed how and when the central bank could reduce its $8.76 trillion in U.S. Treasury and mortgage-backed securities assets, minutes of the meeting showed. In its efforts to stabilize the economy over the past two years, the size of the Fed’s balance sheet has doubled.

Almost all officials agree that it may be appropriate to start the balance sheet reduction at some point after the first rate hike, and that the appropriate time to start the balance sheet reduction may be closer to after the start of the first rate hike than previously expected. Some (some) believe that the Fed should make a strong commitment to address rising inflationary pressures.

In practice, once asset purchases have ceased, the Fed may maintain a stable size of its holdings by reinvesting proceeds from maturing securities in new securities, which should be economically neutral. The Fed can also allow the size of its holdings of securities to shrink, allowing old Treasuries on hand to mature and no longer invest the maturing proceeds in new Treasuries.

Will not follow the previous round-robin path

Fed Chairman Jerome Powell said last month that he and his colleagues had not made any decision on the balance sheet reduction and that discussions could continue at their Jan. 25-26 meeting. But he suggested the Fed was not prepared to follow the path it took from 2014 to 2019.

In the last balance sheet reduction process, the Fed kept its assets roughly unchanged for about two years after the first rate hike, and then gradually reduced its balance sheet in October 2017.

But Fed officials now believe that the current situation is significantly different from the last time the balance sheet was reduced.

The economic outlook in the U.S. is now stronger, with higher inflation and a tighter labor market. The Fed has a larger balance sheet, both in dollar terms and in terms of its ratio to GDP. At the same time, the Fed’s sustained bond-weighted average maturity is shorter. This means that the balance sheet can be reduced faster without a process cap by simply allowing bonds to mature.

JPMorgan Chase believes that this time the Fed may start shrinking its balance sheet much earlier, and it may start shrinking its balance sheet in 2022. Goldman Sachs believes that the new policy for shrinking the balance sheet may be released as soon as the second quarter of this year. If the Fed starts to shrink the balance sheet in the third quarter, the number of Fed rate hikes this year may reach three times.

The reduction process may continue until 2025

In addition to choosing when to start shrinking assets, Fed officials must also decide how to shrink assets.

In the last round of balance sheet reduction, the Federal Reserve, starting in October 2017, allowed some securities ($10 billion) to expire each quarter without renewing purchases, increasing by $10 billion each quarter until the end of 2018.

UBS predicts that the Fed’s balance sheet reduction action may be targeted for three years, starting at the beginning or middle of this year, and ending when the size of the balance sheet falls below US$3 trillion, and the overall size will account for about 2025 in the second half of the year’s GDP. 25%.

The Fed is likely to take a gradual pace, initially reducing Treasuries by $10 billion and mortgage-backed bonds (MBS) by $5 billion per quarter, rising to $20 billion and $10 billion, respectively, in the first quarter of 2023. The reduction may be raised every other quarter, with the goal of reducing the national debt by $40 billion and MBS by $20 billion per quarter.

At this rate, the size of the balance sheet will shrink by $650 billion between mid-2022 and the end of 2023, and by another $1.3 trillion in 2025, which will reduce the size of the Fed’s assets by about $2 trillion.

There are differences in the specific composition of assets

Specific asset composition is also under discussion.

In theory, holding long-term U.S. Treasuries provides more stimulus than holding short-term securities. But the Fed’s portfolio now contains far more short-term Treasuries than it did in the past decade. If officials don’t limit the amount of passive balance sheet reductions, the Fed’s holdings will shrink relatively quickly, by about $3 trillion over two years.

At present, Fed officials are divided on how to structure the asset portfolio: some people believe that the short-term, medium-term and long-term bonds should be held in proportion to the outstanding bond market, which is relatively neutral to the market; others One faction favors a larger holding of short-term Treasuries and other bonds with shorter maturities, which would allow the Fed to quickly switch to longer-term Treasuries to boost stimulus in a downturn.

Notably, the Fed actually suspended passive balance sheet reductions in 2019 and began building assets (re-expansion) later that year amid concerns that too much bank reserves were being drawn from the financial system. It is worth noting that the reduction of the balance sheet in the future will be completed as expected.

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