Ahead of the FOMC: Fed Already Trimming the $4.5 Trillion Balance Sheet

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The week of October 27 was a busy one for the financial markets, and strength continued in both the economy and earnings. The big news on central banking front was that President Mario Draghi and the European Central Bank pledged to cut the monthly bond buying in half but extended how long it would keep buying bonds. The coming week, October 30 to November 3, will be dominated by ongoing efforts around tax reform and who will be the likely successor for Federal Reserve Chair Janet Yellen. This may make a huge difference in U.S. interest rate policy and how fast the Fed will chop down that massive $4.5 trillion balance sheet.

We knew that the Federal Open Market Committee (FOMC) already had pledged to start trimming the balance sheet, and it laid out how it would start doing so. What many investors and economists might not be prepared for is that this trimming appears to be already underway. We will not know how this gets communicated until the FOMC statement on November 1, 2017, but the Fed’s weekly balance sheet trends report signals that some assets have been cut.

After having peaked at just over $4.5 trillion in prior periods, the weekly balance sheet trend showed a decrease of $8.6 billion in net assets. The prior week’s balance sheet trend showed a gain of $10.3 billion. As far as the total assets in securities held outright, the week of October 25 had a $4.7 billion drop to $4.247 trillion. That was still $16 billion higher than the same week a year ago.

What led the decline on the balance sheet to a level of $4.461 trillion was a $7.4 billion drop in mortgage-backed securities (MBS), taking the MBS level down to $1.775 trillion. This is still $25.5 billion higher than the same week of 2016.

Reserve Bank credit was down $5 billion in the week of October 25 from a $13.6 billion gain in the prior week. This was also down $2.4 billion from a year ago.

There was a small gain in the balance of U.S. Treasury securities, but it was so small that it was less than $100 million. The Federal Reserve currently holds $2.465 trillion worth of Treasury bills, notes and bonds.

All in all, it appears that the Fed is sticking with its plan for how it will trim assets. The FOMC previously issued an addendum to the “Policy Normalization Principles and Plans” covering the path of the wind-down of its massive balance sheet. 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.

Depending on which candidate is chosen as the next Fed chair, there is always a possibility that the Federal Reserve will increase or decrease its monthly asset wind-down program. Most likely the wind-down will take years, and so far the consensus seems to be that the Fed’s total balance sheet will shrink to $2.0 trillion to $2.5 trillion.