Wednesday, September 20, 2017, will mark the Federal Reserve’s September Federal Open Market Committee (FOMC) meeting announcement. The announcement also will include forecasts by the Federal Reserve, and more importantly it should contain more detail on how the Fed will begin the long multiyear process of tapering down its massive $4.5 trillion balance sheet.
Prospects for another rate hike are likely to be communicated for later in 2017, but the real issue is around how the Fed will start reducing the balance sheet. The Treasury, agency and mortgage-backed securities purchases were unprecedented in America, so it makes the winding down process all that much more important.
Fed Chair Yellen also will hold a press conference at 2:30. The Fed had indicated back in June that there may be one more interest rate hike in 2017. Economic reports have moderated and inflation has stubbornly remained under the Fed’s 2.0% to 2.5% range. At the same time, wages have begun to increase in 2017 and the official unemployment rate is actually lower than what has historically been viewed as a full employment economy.
The fed funds futures market had a 56% chance for a 0.25% rate hike in fed funds by the December FOMC meeting. That is not very certain, but it is versus just a 37% chance just a month earlier.
The Fed has tentatively laid out how it plans to reduce the balance of Treasury and mortgage-backed securities. The current expectation is that this is set to begin now or in October. It is still an unknown as to just how much the balance sheet will actually be trimmed. With the figure at $4.47 trillion as of September 11, 2017, it seems very unlikely that the Fed will shrink its balance back down to under $900 billion where it was in mid-2008.
By the end of 2008, the Fed’s balance sheet was closer to $2 trillion, and it rose to $3 trillion by early 2013. The balance sheet peaked at about $4.5 trillion by early 2015 and has remained stable ever since.
Predicting an actual end game for the Fed’s balance is very hard, because its unwind might take a decade. If we are using a 10-year horizon, the economy may have had one or two more recessions over that time if economic history were to repeat itself.
For the sake of argument, let’s assume that the Fed’s balance sheet of almost $4.5 trillion will be shrunk down to $2.0 trillion. Let’s also assume that the move takes place over five years or so, using the reasoning outlined below, versus the six years it took to ramp up.
If the $2.5 trillion reduction from $4.5 trillion to $2.0 trillion were to hold up, it would require ceasing reinvesting the principal and interest payments entirely. It would also require for the Fed to sell a combination of close to $500 billion in Treasury, agency debt and mortgage-backed securities per year, if that five-year transition were to come about.
Yellen likely has not forgotten the so-called taper tantrum of 2013. This was when the markets became spooked about a Federal Reserve asset sale plan and a fear of rising rates that might overload the ability of the markets to absorb all that new supply. That fear has now been replaced with calm, but the end result is far from certain. The markets have embraced and started to accept that the Fed’s balance sheet will start to move lower.
For the record, most economists seem to think that the plan is going to take longer than the five years or so suggested here. And any economic hiccup at all in the months or years ahead might further drag out the timeline for a hefty balance sheet reduction.
One potential complication is that Yellen’s term as chairperson comes to an end in 2018. Who will be appointed as the next Fed chair under the current U.S. president is less than certain at this time. Another complication is that Vice Chair Stanley Fischer recently announced his retirement in October of this year to personal reasons. With the other empty board seats, the president may get to appoint four or more new members to the Federal Reserve over the next year, and even more if there are unexpected changes between 2018 and 2020.
What all this adds up to is that the market may have come to have certain expectations from the current Fed but may have an entirely new Fed policy and verbiage that has to be interpreted in 2018.
With its announcements in June, the FOMC issued an addendum to the “Policy Normalization Principles and Plans.” This is the current expected path of how the Fed will begin the wind-down of its massive balance sheet — and its larger target of $30 billion per month after the sales start to occur would imply a much longer exit plan than the five years mentioned above — depending on its added $20 billion cap per month thereafter. That 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.