Can the Federal Reserve avoid an economic catastrophe while offloading billions in bonds from its balance sheet? Colby Smith and Kate Duguid report in the Financial Times:
After months of debate, the US Federal Reserve has a plan to shrink its $9tn balance sheet as it tries to tighten monetary policy and tackle the highest inflation in decades.
Details of the plan were contained in minutes from the latest policy meeting in March, when the Federal Open Market Committee implemented the first interest rate increase since 2018 and signalled its intention to continue raising it to a “neutral” level that neither fuels nor slows growth.
Besides interest rate rises, shrinking the balance sheet is the second pillar of the Fed’s plan to scale back the huge injection of monetary stimulus pumped into the economy at the onset of the pandemic.
“It’s hard to look at the balance sheet plan the FOMC released and get the impression that they are anything but serious about removing policy accommodation,” said Robert Rosener, senior US economist at Morgan Stanley.
Here is what the Fed has proposed and why financial markets are on edge:
How will the Fed shrink the balance sheet?
Officials broadly agree the Fed should shed up to $95bn of assets a month from the central bank’s huge balance sheet, and build up to that level over roughly three months starting in May.
The Fed will seek to “roll off” $60bn of Treasuries each month by not reinvesting the proceeds from maturing bonds. When the amount of maturing Treasuries falls short of that level, the central bank has suggested making up the difference by reducing its holdings of shorter-dated Treasury bills, of which it holds roughly $325bn worth.
The Fed also wants to reduce its holdings of agency mortgage-backed securities (MBS), which it started buying during the pandemic, capping the reduction in this asset class by $35bn a month. However, economists say it may fall short of this target given when the securities are expected to mature.
Stephen Stanley, an economist at Amherst Pierpont, estimates holdings of agency MBS will decline by just $25bn a month. Fed policymakers have said they would consider selling some of the stockpile outright, rather than waiting for the securities to roll off the balance sheet, but this would only happen when the pruning process is “well under way”.
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