Forget the Fed Rate Hikes — It’s All About Shrinking the $4.5 Trillion Balance Sheet

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Forget about being too nervous about the Federal Reserve hiking interest rates. In the September FOMC meeting, Janet Yellen and the FOMC have indicated that most Fed governors are expecting just one more interest rate hike in 2017. And they have even seemed to dial down their expectations over how high rates might be raised in the year or years ahead.

What matters now is that the Federal Reserve is officially setting a plan to shrink its massive $4.5 trillion balance sheet. While the Fed has said it is still rather accommodative, you are right now seeing the start of the second phase that moves to end quantitative easing.

The FOMC statement committed to October as the month that the Federal Reserve will initiate the balance sheet normalization program. Fortunately, this has been described in detail. The one consideration that readers should consider is that the path toward normalization may simply be laid out far too slowly.

While it is a known case for a smaller balance sheet, what is not known right now is by exactly how much the Fed will cut that $4.5 trillion amount. The Fed has maintained its wording around a gradual reduction, but the only real wording about the “how much” is that the balance sheet will be lowered 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.”

Another admission here is that the FOMC said it expects to learn more about the underlying demand for reserves during the process of balance sheet normalization. In short — “We will all find out together, for better or worse.”

The June Addendum said:

The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.

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.

The current plan of shrinking the Fed’s massive balance sheet is probably far from being a one-way ticket. They left multiple outs here, and over the time they would take to shrink the balance sheet there could easily be another recession. Any new recession or economic shock would interrupt the normalization plans on top of gradual rate hikes. The June Addendum said:

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.