Hanging over discussion of Federal Reserve tightening has been a potentially market-shaking question: how to safely unwind the crisis-era asset purchases that bloated the central bank’s balance sheet.
Policymakers led by Janet Yellen, the Fed chair, have approached the topic gingerly, acutely aware of the potential to repeat the so-called taper tantrum of 2013, where ill-timed talk of slowing bond purchases roiled global markets.
Yet for all the nerves, the coming shake-up in the Fed’s balance sheet may end up being far less radical than some investors have believed.
The Fed will need to operate with a much larger balance sheet than before the crisis — at least three times as big, say some investors — in part because of regulatory and other changes governing financial institutions’ appetite for safe assets, as well as an overhaul of the Fed’s rate-setting framework.
“Investors believe that the Fed is going to be very careful about balance sheet reduction, but many don’t realise that the Fed doesn’t have to do that much to get the balance sheet down to the right size,” says Ajay Rajadhyaksha, head of macro research at Barclays.
The fight against financial and economic implosion during the crisis prompted the Fed not only to cut rates to near zero, but also to swell its balance sheet by $3.5tn during quantitative easing. Its holdings now stand at an unprecedented $4.5tn, including $2.5tn of Treasuries and $1.8tn of mortgage-backed securities.
With the Fed’s rate-raising campaign now gathering steam, the Federal Open Market Committee has stepped up its discussion of ways of paring back the size of its balance sheet.
The topic is likely to feature in discussions ahead of this week’s rate-setting meeting, at which the Fed is set to peg rates at their current target range of 0.75 per cent to 1 per cent. Ms Yellen appears ready to set the parameters of the balance-sheet shrinking process before she potentially leaves office in January of next year. That means her successor, if she is not reappointed, will inherit a clear plan rather than a monetary hot potato.
It has the potential to be disastrous if they’re not very very careful
Paring back its balance sheet is a way of further taking the foot off the monetary accelerator. It will help alleviate political pressure from the right over the Fed’s interventions in the economy. Its holdings of mortgage-backed securities are seen as particularly unwelcome, given that they have made the Fed the dominant player in that notionally private market.
To date the markets have appeared unperturbed by the crescendo of Fed talk over balance sheet shrinkage. This is in part because of growing signs that the reduction may be modest. A number of economists expect the balance sheet to settle at 3tn or bigger once a very gradual process of shrinkage has taken place.
There are several reasons for this. The flipside of the assets on the Fed’s balance sheet are liabilities. These include currency in circulation, the Fed’s reverse repurchase agreements, the US Treasury’s Fed bank account, and commercial banks’ excess reserves — the latter having swelled when the Fed was hoovering up stockpiles of Treasuries and MBS during the crisis.
New regulations requiring banks to maintain ample liquidity mean their appetite for central bank reserves and other ultra-safe assets has grown dramatically since before the crisis. What is more, the Fed appears to be deciding against shifting back to its old system of setting rates by varying a scarce supply of reserves. Instead, under its so-called floor system it pays interest at an administered rate on banks’ excess reserves, as well as setting the rate on a reverse repurchase programme with non-bank players such as money market funds.
Ben Bernanke, the Fed’s former chairman, has said that the critical level of reserves needed for the Fed to transmit its monetary policy through the floor system involving excess reserves is well over $1tn. A recent annual report from the New York Fed’s markets desk sketches out scenarios of reserves being anywhere between $100bn to $1tn in the longer term.
Roberto Perli, an economist at Cornerstone Macro, says reserves seem likely to stay at $500bn at least. With currency in circulation continuing to grow steadily with the economy in the coming years, he expects the Fed to shrink its balance sheet at a relatively leisurely pace of $300bn a year over half a decade, taking reserves to just under $3tn. Other analysts see the balance sheet ending up even larger.
The annual tightening entailed in that sort of balance sheet shrinkage is just 16 basis points a year — equivalent to less than a rate rise every year, Mr Perli estimates. “Unless the regulatory environment changes it would be hard for the Fed to go back to the old system of reserve scarcity even if they wanted to,” he said.
How will the Fed’s asset holdings evolve given this outlook? Assuming that the Fed wants to get rid of all its $1.8tn of mortgage bonds as it gingerly retreats from the home loan market, the central bank may have to start buying Treasuries again at the tail-end of the process, Mr Rajadhyaksha predicts.
The Fed is “not going to move aggressively”, says Erin Browne, head of macro investing at UBS O’Connor, a hedge fund. The central bank currently ploughs coupons and repayments back into the market, and she expects it to only start reducing its reinvestment by $10bn a month — split equally between Treasuries and mortgage-backed bonds — from January. That will continue until the balance sheet is roughly at $3.5tn, Ms Browne predicts.
Not all market players are sanguine that the process will unfold smoothly. “They’re hiking rates even as they’re shrinking the balance sheet,” says Michael Mullaney, an analyst at Boston Partners. “It has the potential to be disastrous if they’re not very very careful.”
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