The Fed's plan to shrink its balance sheet, quickly

The Fed plans to reduce its $8.5 trillion balance sheet beginning June 1, when it will no longer reinvest proceeds of up to $30 billion in ... TheFed'splantoshrinkitsbalancesheet,quickly May16,2022|VanguardPerspective TheFed'splantoshrinkitsbalancesheet,quickly JoshHirt,CFASeniorEconomist,VanguardInvestmentStrategyGroup BrianQuigleyVanguardheadofMBS,agencies,andvolatility Withinflationata40-yearhighandthelabormarketstilltight,theFederalReservehaspulledanotherinstrumentfromitsmonetarypolicytoolbox.InadditiontoraisingitskeyinterestratetargetbyhalfapercentagepointonMay4,theFedhassaiditwillstarttoshrinkitsbalancesheet,anotherstepinpost-pandemicpolicynormalization. Expandingthebalancesheetbybuyinggovernmentbondsontheopenmarket,knownasquantitativeeasing,isanunconventionaltoolthattheFedandothercentralbanksusetostimulateeconomieswhenpolicyinterestratesarenearorbelowzeroandcan'teffectivelybeloweredfurther.Now,withratesrising,there'slogicinthebalancesheet'sexpansionbeingreversed. "TheFedhasminimalexperienceinremovingstimulusbyshrinkingitsbalancesheet,"saidJoshHirt,aVanguardsenioreconomistwhostudiestheFed,"somarketsunsurprisinglytakenotice.That'sespeciallytruenowastheFedplanstomovewithalesscautiouscadencecomparedwiththeprevioustimeitemployedquantitativetightening." What'sbehindthefasterpaceofquantitativetightening? TheFedplanstoreduceits$8.5trillionbalancesheetbeginningJune1,whenitwillnolongerreinvestproceedsofupto$30billioninmaturingTreasurysecuritiesandupto$17.5billioninmaturingagencymortgage-backedsecuritiespermonth.BeginningSeptember1,thosecapswillriseto$60billionand$35billion,respectively,foramaximumpotentialmonthlybalancesheetroll-offof$95billion. TheFedendedbondpurchasesonlyinMarch2022,sothistighteningisoccurringconsiderablysoonerthaninthelastreductioncycle.Aftertheglobalfinancialcrisis,theFedendedquantitativeeasingpurchasesin2014butdidn'tstarttoreduceitsbalancesheetuntil2017.Themaximumroll-offthenwasroughlyhalfofthatexpectedthistimearound. Threekeyfactorsexplaintoday'sfasterpace: TheFed'sbalancesheetissignificantlylargerthistimerelativetowhatwouldbeconsideredanoptimalrangetoeffectivelyimplementmonetarypolicy. Theeconomyisatamoreadvancedstageofthebusinesscycleandrunninghotter,asreflectedinasmalleroutputgap,lowerunemployment,andhigherinflationthanin2014. TheFedislikelylessuncertainnowabouthowmarketsandfinancialconditionsmayreactgiventhatithasatleastsomeexperienceincommunicatingandexecutingroll-offplans. TheFed'sbalancesheetroll-off:Differentcircumstances,differentplan Notes:InflationgapisdefinedasthecorePersonalConsumptionExpendituresIndexrelativetotheFederalReserve's2%inflationtarget.EmploymentgapisdefinedastheunemploymentraterelativetoNAIRU,thenon-acceleratinginflationrateofunemployment,theFed'sestimateoflong-rununemployment.OutputgapisdefinedasrealGDPrelativetotheCongressionalBudgetOffice'sassessmentofrealpotentialGDP.Estimateforthebalancesheetroll-offpathassumesthatmonthlyproceedsof$30billioninTreasurysecuritiesand$17.5billioninagencymortgage-backedsecurities(MBS)won'tbereinvestedinthethreemonthsbeginningJune1,2022.BeginningSeptember1,2022,monthlyTreasuryandMBSroll-offcapswillriseto$60billionand$35billion,respectively.ForMBS,roll-offafterSeptember1,2022,assumesforecastedMBSprepaymentspertheFederalReserveBankofNewYork's"FederalReserveAssetPurchases:ThePandemicResponseandConsiderationsAhead,"March2,2022.Consistentwith"PlansforReducingtheSizeoftheFederalReserve'sBalanceSheet,"May4,2022,theestimatedroll-offpaceslowsandthenstopswhenthebalancesheetiswithinrangeofoptimaltoallowassetstogrowintotheoptimalrange.Theoptimalbalancesheetestimatecomprisesaconstant$1.5trillionlevelofrequiredreserves,currencyincirculationgrownby4%nominalGDP,andaconstant2.8%ofGDPallocationforTreasurygeneralaccountandotherliabilitiesasperFedChairmanJeromePowell'sMarch8,2019,speech"MonetaryPolicy:NormalizationandtheRoadAhead." Sources:FederalReserveBankofSt.Louis,Refinitiv,andVanguard. WhyinterestrateswillremaintheFed'sprimarytool Whatlikelywon'tchangeistheFedfavoringthepolicyrateasitsprimarytooltoeffectpolicy,withbalancesheetreductionrunningintheproverbialbackgroundtomaximizepredictabilityandminimizemarketdisruption.That,alongwithconcernsthatbalancesheetreductionwouldleadtomuchhigherinterestratesatthelongendoftheyieldcurve,iswhytheFedsetmonthlycapsforlettingbondsmaturepassivelyratherthanplanningtoactivelysellsecuritiesfromitsportfolio. Anotherconsiderationrelatestotheeventualterminalsizeofthebalancesheetintermsofensuringadequatemarketliquidityandcarryingoutmonetarypolicy,whichwouldserveasaguideforwhentheFedwouldendassetroll-off.Atpresent,thisterminalsizeisuncertain.However,asshowninthegraphicusingsimplifyingassumptions,Vanguardestimatesthatthebalancesheetmaysettlearound18%ofGDP,orjustabove$5trillion,beforetheFedbeginswindingdownandeventuallyendingitsroll-off,atwhichpointitwillallowitsassetstogrowinrelationtothesizeoftheeconomy."Thatlevelcouldbereachedaroundtheendof2025,barringanypausesorsignificantdeviationsfromthecurrentlycommunicatedplan,"Hirtsaid. Achallengingenvironmentforcentralbanksahead TheFed'stighteningplancomeswithchallenges,accordingtoBrianQuigley,VanguardheadofMBS,agencies,andvolatility."Judgingtheappropriatepaceandcumulativeamountoftighteningwillbemoredifficult,"Quigleysaid."TheFedsteppingawayasabuyerofthemarketwillpromptaperiodofadjustmentthatwillrippleacrossfinancialmarketsasvaluationswillhavetocheapentoattractmoreprice-sensitivebuyers.Thatthiswillbehappeningasanumberofothermajorcentralbankswillbehikingratesandunwindingtheirbalancesheetsisacomplicatingfactor." Howeffectivelypolicymakersremoveaccommodationsfromglobaleconomieswillremainacrucialthemefor2022andbeyond.Inthenearterm,Vanguardeconomistscontinuetoexpectthateconomicgrowthandthelabormarketwillmoderatebutremainstrongtowardyear-end.Coremeasuresofinflation(removingvolatilefoodandenergyprices)aresimilarlyexpectedtomoderatethroughouttheyearbuttostayatlevelswellabovetheFed's2%target. Amidachallengingenvironmentforcentralbankstobalanceinflationdynamics,thepaceandeventualendpointofpolicyrateincreaseswilllikelyremainafocalpointbeyond2022. ThisarticleislistedunderU.S.