Evdokia Pitsillidou, Head of Risk Management at easyMarkets. She specialises in commodities, options and currencies and loves to solve analytical problems and overcome challenges.

After years of easy monetary policy, the Fed (Federal Reserve) is getting ready to scale back the size of its balance sheet in the coming months. That much was gleaned from the May Federal Open Market Committee (FOMC) meeting, where officials appeared to be in synch over the need to unwind their oversized holdings of Treasuries and mortgage-backed securities. However, as is usually the case with monetary policy, implementing this vision is easier said than done.

Will the Fed Unfold its Balance Sheet?

With interest rates rising steadily over the past nine months, tackling the balance sheet is the next logical course of action for the Fed. However, officials have given scant details about what that process will look like. The minutes of the May policy meeting showed officials backing a system that will introduce cap limits on how much they can roll off each month without reinvesting.[1]

To be sure, the Fed has many tools by which it can begin to reduce its balance sheet, which currently sits at a whopping $4.5 trillion. The challenge is doing so in a way that doesn’t disrupt the market, which is already anxious about the central bank’s plans. In particular, investors are concerned about the impact of the Fed’s actions on liquidity and public supply of Treasuries.[2]

Beyond these initial concerns, market participants are likely pondering what the mix will be in the run-down between Treasuries and mortgage-backed securities. The exact timing of the balance sheet reduction, not to mention the size of the monthly caps, are also critical.

How Much Would the Fed Reduce the Balance Sheet?

There’s also no word on just how large the wind-down will be. Policymakers have repeatedly stressed that the balance sheet may remain large compared to the size of their holdings before the financial crisis. There are many reasons why the Fed may opt to keep a larger portfolio – chief among them being the new policies they’ve adopted for controlling short-term interest rates. This was aptly conveyed by Fed Governor Jerome Powell, who said back in June that it’s “hard to see” the balance sheet falling below $2.5 trillion.[3]

Markets will likely learn a lot more about the Fed’s plans at the next FOMC meeting scheduled for September 19-20. The official rate statement will be accompanied by quarterly economic projections covering GDP, inflation and unemployment.

The 2008 financial crisis had devastating consequences on the U.S. economy, resulting in years of quantitative easing and zero-bound interest rates. The Fed ended its QE program in October 2014[4] and has been raising interest rates gradually since December 2015. The pace of those hikes has accelerated over the past nine months, with the Fed introducing three quarter-point raises since December.

[1] Jeff Cox (24 May 2017). “Fed sets process to wind down $4.5 trillion balance sheet.” CNBC.

[2] Christopher Condon and Mattew Boesler (6 July 2017). “Five Questions About the Fed’s $4.5 Trillion Balance Sheet.” Bloomberg Markets.

[3] Christopher Condon and Mattew Boesler (6 July 2017). “Five Questions About the Fed’s $4.5 Trillion Balance Sheet.” Bloomberg Markets.

[4] Samantha Sharf (29 October 2014). “Fed Ends QE, Perks Up Labor Market Outlook.” Forbes.

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