The End of Quantitative Easing: Fed Rate Hike Trumped by Selling Down Massive Balance Sheet

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Janet Yellen and the Federal Open Market Committee have confirmed what the market was bracing for (or hoping for) — a Fed Funds rate hike. What is also now on the table is that the Federal Reserve has released an exact gradual path to lower its massive $4.4+ trillion balance sheet holdings. This is more than just a move toward normalization of interest rates. Some investors and economists will interpret Wednesday’s rate hike and balance sheet decision as the beginning of the final steps toward ending America’s quantitative easing.

Right before the 2:00 pm Eastern Time “Fed-Time” release, the FedWatch Tool was calling for a 95.8% chance of a 25-basis point rate hike in Fed Funds. That was lower earlier in the same morning but it had been over 99% last week.

The FOMC voted unanimously to raise the target range for the federal funds rate to 1.00% to 1.25%. The FOMC also said that its stance of monetary policy remains accommodative and supports some further strengthening in labor market conditions and a sustained return to 2 percent inflation. While the FOMC is still maintaining its existing policy of reinvesting principal payments from debt interest payments and of rolling over maturing Treasury securities at auction, they did outline a path to lightening up on that massive balance sheet.

The FOMC’s opening statement outlines the current view of the economy:

Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined. Household spending has picked up in recent months, and business fixed investment has continued to expand. On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

The FOMC now expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated. This program was outlined as an addendum to the Committee’s Policy Normalization Principles and Plans.

In an effort to lower the Treasury and mortgage-backed securities holdings, the FOMC plans to decrease its reinvestment of the principal payments it receives from securities held and such payments will be reinvested only to the extent that they exceed gradually rising caps.

The FOMC’s planned outline for how the balance sheet will be shrunk was stated as follows:

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

Gradually reducing the Federal Reserve’s securities holdings will result in a declining supply of reserve balances. The Committee currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.

The Committee affirms that changing the target range for the federal funds rate is its primary means of adjusting the stance of monetary policy. However, the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.