The uncertainties of the Fed’s balance sheet reduction

After yesterday’s FOMC meeting it is now clear that the Fed will give the starting signal for balance sheet normalisation relatively soon. This is likely to be in September provided that hitting the U.S. debt ceiling will not lead to any great anxiety at this time. The Fed affirmed that the reduction of the balance sheet will proceed very slowly, thereby ensuring that no serious consequences for the financial markets will be unleashed. Despite this pledge, some market players are asking themselves whether the reduction of the Fed’s balance sheet is actually just a storm in a teacup or if it could yet cause an unforeseen tsunami?

The Fed has already announced the extent to which portfolios of both U.S. Treasuries and mortgage backed securities (MBS) will be sold off as part of a transparency drive. Should an optimal balance sheet total of around USD 2,000bn-2,500bn be achieved by around the end of 2021, the Fed may be able to further reduce its MBS holdings. In order that the balance sheet doesn’t shrink further within this range, the Fed would buy U.S. Treasuries to offset this. In this way the central bankers intend to return to a portfolio consisting exclusively of U.S. Treasuries in the medium term. The volume of bonds falling due varies considerably from month to month. If only a small number of securities fall due in one month, the Fed would be forced to proactively sell bonds in order to achieve their announced balance sheet reduction.

The restrictive effect of the announced balance sheet reduction (USD 600bn annually) could well influence the future pace of key rate hikes. Based on a study conducted by the Kansas City Fed, a reduction of the Fed’s holdings by USD 675bn per annum would necessitate around two key rate hikes of 25 basis points per year – with the balance sheet normalisation and the key rate hikes, monetary policy would then be significantly tightened. The Fed is hoping that its balance sheet reduction will take place almost in slow motion, and will therefore be predictable for the markets. However, in the light of the economic, financial and political circumstances, and in view of the time frame required for the portfolio reduction, this plan may well entail much more turbulence than expected.

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