As the Federal Reserve gradually begins tightening monetary policy, its next task is addressing the $4.5 trillion elephant in the room: its swollen balance sheet.

Beginning in late 2008, the Fed began large-scale purchases of assets such as U.S. treasuries and government-supported mortgage-backed securities (MBS) to stave off a complete collapse of the financial system. For six years, the Fed embarked on this asset purchase program — known as quantitative easing — which kept interest rates at record-low levels in the hope that increased bank lending would spur growth. The effectiveness of the program will never really be known (a counterfactual scenario in which there never was QE cannot be tested), but the financial system in the U.S. did survive a scare of historic proportions. Some will argue QE went on for too long leading to overinflated asset prices, but we leave that debate for another day. (See also: Understanding the Fed's Balance Sheet.)

On October 29, 2014, when Fed Chair Janet Yellen announced the end of the bond-buying program, the Fed's balance sheet had reached $4.48 trillion. By reinvesting principal payments and maturing securities, the balance sheet has remained at or about $4.5 trillion since. According to weekly data published by the Fed, its balance sheet consists of $2.5 trillion in treasuries and $1.8 trillion in mortgage-backed securities. (See also, Central Banks' $13 Trillion Problem.)

Total Assets of the Federal Reserve Banks

As economic conditions continue to improve, evident in the labor market and rising inflation, the Fed faces growing pressure to address its balance sheet. In December, the Fed stated it would not begin the process of shrinking its balance sheet until "normalization of the level of the federal funds rate is well under way." When that will be, or more importantly, at what level Fed officials believe normalization is underway remains unknown. Putting this subjective notion aside, when the Fed does begin to reduce its balance sheet, it will do so in one of two ways. It can sell securities on its balance sheet, or it can choose not to reinvest maturing securities.

Selling Securities

Until the election of Donald Trump the chances of the Fed actively selling securities to reduce its balance sheet was unlikely. Under this scenario — a more aggressive path of balance sheet reduction — selling securities would put pressure on the bond market, which could cause interest rates to increase rapidly, leading to unwanted volatility in financial markets. However, Trump has been highly critical of Yellen and the Fed's low interest rate policy and if he chooses to shake up the Fed it could shift the strategy of the central bank. "This could be important for balance sheet policy because many Republican-leaning economists have criticized quantitative easing and have expressed a preference for rapid balance sheet rundown, perhaps even through asset sales," Daan Struyven, a Goldman economist said, according to CNBC. (See also: How Trump Could Quickly Shake Up the Fed.)

In a January blog post titled "Shrinking the Fed's balance sheet," former Fed Chair Ben Bernanke warned against the Fed actively trading its balance sheet. "I worry though that, in practice, attempts to actively manage the unwinding process could lead to unexpectedly large responses in financial markets," Bernanke said.

In May 2013, the Fed announced it would taper back its $70 billion-a-month bond-buying program. The announcement caused panic selling in U.S. Treasury markets and interest rates surged higher. The day became known as the taper tantrum.

Maturing: The Mature Approach

By simply letting the balance sheet slowly decline by not reinvesting the maturing assets is an easy path for the reduction in the balance sheet. While the Republicans argue that the pace of reduction should be swift, it is worth noting that $1.4 trillion of the $2.5 trillion in Treasuries have maturities of less than five years. Additionally, if the Federal Reserve is to keep its balance sheet large permanently — something Bernanke has argued for — the short duration of these securities makes the argument for letting the assets mature over time the more mature and stable approach.

Bernanke argues the Fed should keep a large balance sheet to improve the ability of the Fed to provide assets in a crisis. (See also: Opinion: The Fed is a Dead Dove Walking.)

The Beginning

Minutes from the March Federal Reserve meeting showed that Fed officials backed a plan that would begin reducing the $4.5 trillion balance sheet towards the end of 2017. "Most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the committee’s reinvestment policy would likely be appropriate later this year," the minutes said.

Three months later these plans became more clear. At the Federal Reserve June meeting, committee members stated that they plan to begin tapering by letting $6 billion a month in maturing Treasuries run off, which will slowly increase over the coming months. "For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month," the Fed said.

With regards to its agency debt and Mortgage-Backed Securities (MBS), the Fed laid out a similar plan where it will begin tapering $4 billion a month until it reaches $20 billion.

Additionally, the Fed said the long-run plan is to keep the balance sheet "appreciably below that seen in recent years but larger than before the financial crisis."

Two weeks after the June Fed meeting the minutes showed that timing around when tapering should begin remains up for debate as some officials worry about possible chinks in the underlying economy. "Several preferred to announce a start to the process within a couple of months; in support of this approach, it was noted that the Committee's communications had helped prepare the public for such a step. However, some others emphasized that deferring the decision until later in the year would permit additional time to assess the outlook for economic activity and inflation," the minutes said.

The one caveat continues to be inflation. The hawks remained confident that while underlying inflation is yet to hit 2 percent, they believe a gradual reduction in the balance sheet will not affect pricing pressures. On the other hand, the doves voted to buy more time saying it is prudent to wait and "assess the outlook for economic activity and inflation."

The Bottom Line

The combination of the new presidency and an improving U.S. economy has bought the balance sheet back into play. A highly critical Republican government that will likely replace Fed Chair Janet Yellen and Vice Chair Stanley Fischer in early 2018 looks set to put focus on the balance sheet.

With these concerns, and a somewhat improving economy, the Fed laid out plans to begin tapering $10 billion in assets a month made up of $6 billion in Treasures and $4 billion in MBS.

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