Interest rates aren’t the only thing Federal Reserve officials gathered in Washington this week are debating.
The Fed has telegraphed a clear intention to begin unwinding a key policy tool deployed during the Great Recession as it seeks to reduce the size of its $US4.5 trillion balance sheet, now some five times larger than its pre-crisis total.
The Fed resorted to buying Treasury and mortgage bonds on a large scale starting during the depths of the financial meltdown and through the recovery, an effort to keep borrowing costs down when official interest rates were already at zero. Since then, the central bank has bought new bonds with the proceeds from ones that mature.
Now the Fed would like to cease this reinvestment policy, but is being especially cautious about sending a clear signal to the market, having been burned by a bad experience in 2013. At the time, a mere hint from then Fed Chairman Ben Bernanke that the central bank would start reducing the pace of bond buys sent fixed-income markets into a tizzy, tightening financial conditions sharply and unexpectedly. The event became known as the “taper tantrum.”
There is particular worry about unsettling the housing market, a key and intended beneficiary of the program because it stood at the center of the banking crisis.
To help clarify what is a rather wonky discussion with a few elucidating pictures, Societe Generale has issued a useful report laying out the wheres and whys of the Fed’s asset portfolio.
First, here’s a depiction of the Fed’s balance sheet from both the asset and liabilities side, which helps clarify the rather counterintuitive accounting that goes along with being the nation’s monetary authority. The charts include a breakdown by type of asset that shows just how much the Fed’s holding of mortgages and Treasuries expanded starting in 2008.
Below are SocGen’s estimates for how the Fed will try to wind down its balance sheet.
Still there are different ways the Fed could go. Here’s SocGen’s prediction of what an updated version of the “normal” balance sheet looks like:
How much monetary tightening will the Fed’s balance sheet reduction generate? “Our two estimates imply an impact of 40-60 basis points on Treasuries yields for our core scenario for tapering of reinvestments,” SocGen economists write.
Finally, here’s a useful breakdown of when the existing securities on the Fed’s portfolio are due to mature.
For more on the Fed’s own thinking about the balance sheet, here is a recent analysis by Fed board staffers.