Fed Chair Janet Yellen and policy makers are preparing to reduce the central bank's massive asset portfolio this year which has more than quadrupled in size to $4.45 trillion since 2007, following monetary stimulus including multiple rounds of quantitative easing (QE). Yellen has said the central bank will start reducing the portfolio once rates increases are "well under way," according to the Wall Street Journal.

This proposed tapering is a move that risks jolting the markets by boosting costs on bonds and mortgages, the Journal says. There are risks and negative implications to this move, but potential upsides too. (For more, see: Understanding The Federal Reserve Balance Sheet.)

The Fed will give its view of the markets today as the central bank announces its latest policy decision. While no rate increase is expected, several Fed policy makers have said it's likely that the Fed will raise rates several times this year after boosting them in December for the second time in a year.

From Accumulation to Divestment

In the wake of the 2008 financial crisis, the Federal Reserve (as well as foreign central banks) began to stabilize the economy by using a number of monetary policy tools. This included lowering interest rates and buying many billions of dollars worth of long-term U.S. Treasuries and billions more in mortgage backed securities (MBS). The result was a ballooning of the Fed's balance sheet from under $1 trillion to nearly $4.5 trillion in less than a decade. With the economy recovering today and the Fed already raising short term interest rates, reducing these bond holdings seems like a pragmatic policy decision. But, according to the Journal's January 29 story, "a great deal is at stake with the bond decision. Shrinking the portfolio could jolt financial markets, pushing up interest costs on government debt and mortgage bonds and reverberating through the broader economy." (See also: Trump Allies Attack $4.5 Trillion Fed Balance Sheet)

Never before has such a massive portfolio needed liquidation, so the market reaction to that decision is largely unknown. However, financial theory tells us that introducing a large supply of bonds to the market will lower their price, and as bond prices go down, interest rates go up. This means that long-term rates could pop in tandem with short-term rates pushed up by the target rate. One proposed solution to inundating the market with bonds is to stop the practice of reinvesting interest received on existing holdings to make new purchases. Over time, as the bonds mature the balance sheet will decline. Also, as the economy expands, the Fed might be able to "grow into" the balance sheet. In that scenario, even if the optimal size today is closer to $2.5 trillion, robust economic growth could make $4.5 trillion appropriate in just a few years. Therefore, a wait-and-see approach could be prudent. The Journal reports that most traders anticipate no significant change to the balance sheet size over the next 18 months.

The Bottom Line

With the economy growing and interest rates rising, the Fed is seriously looking at its balance sheet - which has ballooned more than fourfold in the past decade following the 2008 financial crisis - and considering reducing its holdings. The size of the holdings have some concerned that actively reducing the position could send jitters through the market.