When it comes to supporting an ailing economy, the Federal Reserve has a powerful tool in the federal funds rate. By lowering the overnight interbank lending rate, the central bank can increase financial liquidity and the supply of credit in the banking system.
Yet fed funds rate cuts to near zero amid the 2007-2008 financial crisis, and again upon the arrival of the COVID-19 pandemic, proved insufficient to bolster the economy and restore normal function to debt markets. That prompted the Fed to embark on large-scale asset purchases (LSAPs), also known as quantitative easing (QE).
On both occasions, the Fed's debt purchases helped to deliver relief by lowering longer-term interest rates, giving the economy a tangible boost. They also signaled the Fed's determination to keep interest rates low, encouraging investment by increasing risk appetite in financial markets.
The Fed's success earned it the reward of having to figure out when and how to unwind at least some of those asset purchases. Managing the composition of the Fed balance sheet and the effect of asset sales on financial markets and the broader economy remains a crucial Fed role.
- The Federal Reserve's securities holdings peaked at $8.5 trillion in March 2022.
- The Fed can reduce its balance sheet by electing not to reinvest some or all of the principal repaid when securities mature, a practice known as runoff.
- The Fed can also sell securities ahead of the maturity date.
- Reductions in the Fed's balance sheet reflect economic gains made possible, in part, by previous Fed asset purchases.
- In June 2022, the Fed began reducing its Treasury debt holdings by $30 billion and its mortgage-backed securities (MBS) holdings by $17.5 billion monthly, with plans to double those monthly cuts starting in September.
Understanding the Fed's Balance Sheet
The Federal Reserve's assets peaked most recently at $8.92 trillion on March 30, 2022. As of Jun. 2, 2022, they included $8.5 trillion in securities held outright. U.S. Treasury securities, mostly notes and bonds, accounted for $5.77 trillion of the total. The Fed also held mortgage-backed securities (MBS) worth $2.71 trillion.
The Fed added assets worth approximately $2.8 trillion in the aftermath of the 2007-2008 financial crisis. The COVID-19 pandemic and the resulting financial panic impaired credit markets to such an extent that the Fed was forced to buy more than $100 billion in securities on a daily basis during the worst days in March 2020. The Fed eventually settled on a pace of $120 billion in monthly purchases, comprising $80 billion in Treasury debt and $40 billion in MBS. It increased its balance sheet by a total of $4.6 trillion in two years through March 2022.
The Fed began reducing the pace of its securities purchases in November 2021 and brought them to a close in March 2022. In May 2022 the Fed's Federal Open Market Committee (FOMC) said the Fed would reduce its holdings by $30 billion in Treasury securities and $17.5 billion in agency debt and agency MBS monthly starting in June, and by $60 billion in Treasury securities and $35 billion in agency debt and MBS monthly from September 2022. That faster rate of balance sheet reduction would put the Fed on pace to shrink its assets by $1.14 trillion annually.
The FOMC said balance sheet reduction would continue until the point, otherwise unspecified, at which the balance sheet is just large enough to efficiently implement monetary policy, primarily by continuing to target the federal funds rate.
In a previous statement on the principles of balance sheet reduction, issued in January 2022, the FOMC said the fed funds rate remains its primary monetary policy tool, and said it planned to reduce its balance sheet primarily by adjusting the amounts reinvested from maturing securities. That means the Fed plans to continue buying Treasury debt and MBS, just not as fast as the securities it now holds mature and are redeemed. The FOMC also said it plans to hold primarily Treasury securities in the long run, "thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy."
The statement implied the Fed plans to eliminate its holdings of MBS over time. The Fed's MBS purchases starting in 2020 helped to drive down mortgage rates, boosting housing demand, even as materials shortages and other market inefficiencies constrained supply.
Fed plans have changed to accommodate a change in economic circumstances previously, notably when efforts to shrink the Fed's balance sheet starting in 2017 foundered amid the COVID-19 pandemic. The FOMC statements on balance sheet reductions in January and May 2022 noted details of the plan were subject to change based on economic and financial developments.
Balance Sheet Options: Reinvestment, Runoff and Selling
The Fed's assets consist largely of debt securities, and like any bond portfolio it forces its managers to make choices as debt matures and the duration of holdings declines over time.
The Fed can reinvest all proceeds from maturing securities, or it can reinvest only a portion of the proceeds, as it chose to start doing in June 2022, in order to reduce the balance sheet gradually.
Fed assets would decline even faster if it chose not to reinvest any of the proceeds from matured securities, a tactic known as portfolio runoff.
Finally, if the Fed wanted to reduce the size of its balance sheet more rapidly than portfolio runoff would permit, it could sell some of its securities.
The Fed has an interest in ensuring its balance sheet reduction doesn't reverse the economic gains secured by the balance sheet's prior expansion. Partial reinvestment ensures the Fed remains a buyer of securities, while portfolio runoff doesn't add to their supply. Selling securities before they mature runs a greater risk of a significant increase in yields, the opposite of the effect of the Fed's asset purchases.
Whether sales are required to reduce the balance sheet depends on the desired reduction pace relative to the maturity schedule of the holdings. The Fed's asset purchases before the COVID-19 pandemic were mostly of long-term debt. After COVID-19 it bought securities of various durations, giving itself more flexibility to reduce those holdings through runoff.
Treasuries vs. MBS
When the Fed buys debt securities, the buying drives up their price, thereby lowering the yield. When the Fed buys Treasury securities, the reduced yield produces debt interest savings for the U.S. government.
In contrast, when the Fed buys MBS, the resulting interest savings are eventually passed on to home buyers in the form of lower mortgage rates. Home buying, in turn, stimulates purchases of appliances and furniture, and supports a large home building industry. As a result, reduced MBS yields stimulate the economy more directly than reduced Treasury yields. The smaller size of the MBS market relative to that for Treasury debt also means the Fed can move yields more dramatically per dollar spent.
Reductions in the Fed's MBS holdings will directly affect mortgage rates, and through them the housing market and the broader economy. The FOMC's January 2022 reference to limiting long-term holdings to Treasuries so as not to affect the allocation of credit across sectors of the economy strongly suggests that's exactly the effect Fed policymakers attribute to the Fed's MBS purchases. The unavoidable implication is that at least some at the Fed feel it contributed to an overheated housing market in 2021-2022.
If the Fed moves from capping reinvestment in MBS to outright selling, the housing market is likely to feel the effect in the form of even higher mortgage rates.
The Bottom Line
The shrinking of the Fed's balance sheet should be viewed as a victory, since only improvement in the economy's prospects is likely to bring it about. Because the Fed controls the U.S. currency, its balance sheet is practically limited only by the availability of assets and the Fed's preference for not usurping markets' role in setting securities prices and allocating economic resources.
By shrinking the balance sheet, the Fed runs the risk of reversing some of the benefits accrued by its expansion. But if the economy is truly on the mend, it's likely to weather gradual change in the Fed's securities portfolio.