As the Federal Reserve gradually begins tightening monetary policy, its next task is addressing the $6.5 trillion elephant in the room: its swollen balance sheet.
Beginning in late 2008, the Fed began large-scale purchases of assets, such as US 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 be known (a counterfactual scenario in which QE did not exist cannot be tested), but the financial system in the US 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.
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 since remained at or about $4.5 trillion until the COVID-19 pandemic in early 2020. According to weekly data published by the Fed, its balance sheet consists of $5.6 trillion in treasuries and $1.6 trillion in mortgage-backed securities.
As economic conditions continue to improve, evident in the labor market and rising inflation, albeit gradual, the Fed faces growing pressure to address its balance sheet. In December 2016, 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 at what level Fed officials believe normalization will occur remains unknown. Putting this subjective notion aside, when the Fed begins 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.
- The US Federal Reserve's balance sheet has been at $4.5 trillion since 2014.
- The Fed can reduce its balance sheet by selling its balance sheet securities or ceasing to reinvest maturing securities.
- During Fed meetings, committee members proposed letting $30 billion in maturing US Treasuries and $20 billion in Mortgage-Backed Securities (MBS) runoff per month.
- The $50 billion per month tapering off plan was initiated in October 2017, and it is expected that, with this plan, the balance sheet will be below $3 trillion by 2020.
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; 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.
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 $85 billion-a-month bond-buying program. The announcement caused panic selling in US 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 over $2.3 trillion of the $4 trillion in Treasuries have maturities of five years or less. 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.
Minutes from the March 2017 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 noted.
Three months later these plans became clearer. At the June Federal Reserve meeting, committee members stated that once tapering begins, they will let $6 billion a month in maturing Treasuries runoff, which will slowly increase to $30 billion over the coming months.
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."
On September 20, 2017, the Fed officially announced lift-off. The unwinding of the balance sheet was underway. The $50 billion per month taper would begin in October, and at this rate, the balance sheet would drop below $3 trillion in 2020 at which point the next discussion will be how big should the Fed's balance sheet remain once tapering is over.
The Bottom Line
It has been over a decade since the Fed launched what was, at the time, one of the bolder monetary policy moves in recent history. In the space of a few years, the Fed quadrupled its balance sheet in an attempt to fight off a fully-fledged banking collapse.
Years later, most participants agree that the Fed prevented a fully-fledged disaster. However, just as they agree with the QE program, they are just as unanimous that unwinding the trillion dollar balance sheet will be a delicate task in itself. And just like the asset purchasing program, only time will tell.