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Fed: the difficult task of shrinking the balance sheet

Certainly, history will show that it is much easier for the major central banks to put quantitative easing measures in place than to remove them.The minutes of the FOMC meeting that took place on 3 May showed that discussions on the reduction of the Fed's balance sheet had made the least headway. The issue is whether and how to stop reinvesting the maturing securities (Treasury securities and MBS) that the Fed holds. The system being considered would introduce “caps” on the dollar amounts of Treasury and agency securities that would be allowed to run off each month (ie that would not be reinvested). These “caps” would be revalued upward every three months.

For the FOMC, beginning non-reinvestments with limited quantities would have the advantage of avoiding spikes in bond yields.While the Fed's asset purchases had reduced the supply of Treasury securities available for non-Fed investors, the non-reinvestment of maturing securities held by the Fed will increase the supply of Treasury securities available for investors. Recently, the Fed's research documents have shown that the impact of the Fed's balance sheet reduction on the term premium would be very gradual: according to the Fed's economists, the three Quantitative Easing operations and the Operation Twist lowered the 10-year yield by 100 bp, and the gradual reduction of the balance sheet would attenuate this impact to 70 bp by end 2018.

Imagine, for example, that the FOMC opts for this mechanism when they meet in September, and that the non-reinvestment begins in October, with a non-reinvestment cap of $15 bn per month, revised upward to $30 bn starting in January, then $45bn starting in April and that the non-reinvestment be total starting in Q3 2018 and until the balance sheet is normalised. In this case, the non-Fed investors should absorb around $ 800 bn long-term Treasury securities in 2018 and more than $ 950 bn in 2019, what would be back to 2013 quantities (see the opposite chart). 

FOMC members would not alter this mechanism for reducing the balance sheet as long as there were no "material deterioration in the economic outlook." Not particularly anxious on economic growth, the members are asking more questions about inflation, with the recent decline in underlying inflation after a two-year upward trend, but also that of market inflation expectations.

Thereafter, the start of non-reinvestment of maturing securities will raise the issue of substitutability between fed funds increases and balance sheet reduction. A note from the Fed of Kansas City finds that a $675 bn reduction in the Fed’s balance sheet over a two-year horizon is about equivalent to a 25 basis point hike in the funds rate. New York Fed Chair Bill Dudley said in April: "If we start to normalize the balance sheet, that’s a substitute for short-term rate hikes, and we might actually decide at the same time to take a little pause in terms of raising short-term interest rates." The opportunistic Fed will not let it pass that the markets are pricing June's rate increase. But things will get more complicated after that, especially if the outlook for the fiscal stimulus considered earlier does not materialise

 

 

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Bastien DRUT, Strategy and Economic Research at Amundi
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Fed: the difficult task of shrinking the balance sheet
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