How Does the Fed Reduce Its Balance Sheet? - Investopedia

The Fed can reduce its balance sheet by electing not to reinvest some or all of the principal repaid when securities mature, a practice known as ... TableofContents Expand TableofContents UnderstandingtheFed'sBalanceSheet BalanceSheetOptions:Reinvestment,RunoffandSelling Treasuriesvs.MBS TheBottomLine MonetaryPolicy FederalReserve Whenitcomestosupportinganailingeconomy,theFederalReservehasapowerfultoolinthefederalfundsrate.Byloweringtheovernightinterbanklendingrate,thecentralbankcanincreasefinancialliquidityandthesupplyofcreditinthebankingsystem. Yetfedfundsratecutstonearzeroamidthe2007-2008financialcrisis,andagainuponthearrivaloftheCOVID-19pandemic,provedinsufficienttobolstertheeconomyandrestorenormalfunctiontodebtmarkets.ThatpromptedtheFedtoembarkonlarge-scaleassetpurchases(LSAPs),alsoknownasquantitativeeasing(QE). Onbothoccasions,theFed'sdebtpurchaseshelpedtodeliverreliefbyloweringlonger-terminterestrates,givingtheeconomyatangibleboost.TheyalsosignaledtheFed'sdeterminationtokeepinterestrateslow,encouraginginvestmentbyincreasingriskappetiteinfinancialmarkets. TheFed'ssuccessearnedittherewardofhavingtofigureoutwhenandhowtounwindatleastsomeofthoseassetpurchases.ManagingthecompositionoftheFedbalancesheetandtheeffectofassetsalesonfinancialmarketsandthebroadereconomyremainsacrucialFedrole. KeyTakeaways TheFederalReserve'ssecuritiesholdingspeakedat$8.5trillioninMarch2022. TheFedcanreduceitsbalancesheetbyelectingnottoreinvestsomeoralloftheprincipalrepaidwhensecuritiesmature,apracticeknownasrunoff. TheFedcanalsosellsecuritiesaheadofthematuritydate. ReductionsintheFed'sbalancesheetreflecteconomicgainsmadepossible,inpart,bypreviousFedassetpurchases. InJune2022,theFedbeganreducingitsTreasurydebtholdingsby$30billionanditsmortgage-backedsecurities(MBS)holdingsby$17.5billionmonthly,withplanstodoublethosemonthlycutsstartinginSeptember. UnderstandingtheFed'sBalanceSheet TheFederalReserve'sassetspeakedmostrecentlyat$8.92trilliononMarch30,2022.AsofJun.2,2022,theyincluded$8.5trillioninsecuritiesheldoutright.U.S.Treasurysecurities,mostlynotesandbonds,accountedfor$5.77trillionofthetotal.TheFedalsoheldmortgage-backedsecurities(MBS)worth$2.71trillion. TheFedaddedassetsworthapproximately$2.8trillionintheaftermathofthe2007-2008financialcrisis.TheCOVID-19pandemicandtheresultingfinancialpanicimpairedcreditmarketstosuchanextentthattheFedwasforcedtobuymorethan$100billioninsecuritiesonadailybasisduringtheworstdaysinMarch2020.TheFedeventuallysettledonapaceof$120billioninmonthlypurchases,comprising$80billioninTreasurydebtand$40billioninMBS.Itincreaseditsbalancesheetbyatotalof$4.6trillionintwoyearsthroughMarch2022. TheFedbeganreducingthepaceofitssecuritiespurchasesinNovember2021andbroughtthemtoacloseinMarch2022.InMay2022theFed'sFederalOpenMarketCommittee(FOMC)saidtheFedwouldreduceitsholdingsby$30billioninTreasurysecuritiesand$17.5billioninagencydebtandagencyMBSmonthlystartinginJune,andby$60billioninTreasurysecuritiesand$35billioninagencydebtandMBSmonthlyfromSeptember2022.ThatfasterrateofbalancesheetreductionwouldputtheFedonpacetoshrinkitsassetsby$1.14trillionannually. TheFOMCsaidbalancesheetreductionwouldcontinueuntilthepoint,otherwiseunspecified,atwhichthebalancesheetisjustlargeenoughtoefficientlyimplementmonetarypolicy,primarilybycontinuingtotargetthefederalfundsrate. Inapreviousstatementontheprinciplesofbalancesheetreduction,issuedinJanuary2022,theFOMCsaidthefedfundsrateremainsitsprimarymonetarypolicytool,andsaiditplannedtoreduceitsbalancesheetprimarilybyadjustingtheamountsreinvestedfrommaturingsecurities.ThatmeanstheFedplanstocontinuebuyingTreasurydebtandMBS,justnotasfastasthesecuritiesitnowholdsmatureandareredeemed.TheFOMCalsosaiditplanstoholdprimarilyTreasurysecuritiesinthelongrun,"therebyminimizingtheeffectofFederalReserveholdingsontheallocationofcreditacrosssectorsoftheeconomy." ThestatementimpliedtheFedplanstoeliminateitsholdingsofMBSovertime.TheFed'sMBSpurchasesstartingin2020helpedtodrivedownmortgagerates,boostinghousingdemand,evenasmaterialsshortagesandothermarketinefficienciesconstrainedsupply. Fedplanshavechangedtoaccommodateachangeineconomiccircumstancespreviously,notablywheneffortstoshrinktheFed'sbalancesheetstartingin2017founderedamidtheCOVID-19pandemic.TheFOMCstatementsonbalancesheetreductionsinJanuaryandMay2022noteddetailsoftheplanweresubjecttochangebasedoneconomicandfinancialdevelopments. BalanceSheetOptions:Reinvestment,RunoffandSelling TheFed'sassetsconsistlargelyofdebtsecurities,andlikeanybondportfolioitforcesitsmanagerstomakechoicesasdebtmaturesandthedurationofholdingsdeclinesovertime. TheFedcanreinvestallproceedsfrommaturingsecurities,oritcanreinvestonlyaportionoftheproceeds,asitchosetostartdoinginJune2022,inordertoreducethebalancesheetgradually. Fedassetswoulddeclineevenfasterifitchosenottoreinvestanyoftheproceedsfrommaturedsecurities,atacticknownasportfoliorunoff. Finally,iftheFedwantedtoreducethesizeofitsbalancesheetmorerapidlythanportfoliorunoffwouldpermit,itcouldsellsomeofitssecurities. TheFedhasaninterestinensuringitsbalancesheetreductiondoesn'treversetheeconomicgainssecuredbythebalancesheet'spriorexpansion.PartialreinvestmentensurestheFedremainsabuyerofsecurities,whileportfoliorunoffdoesn'taddtotheirsupply.Sellingsecuritiesbeforetheymaturerunsagreaterriskofasignificantincreaseinyields,theoppositeoftheeffectoftheFed'sassetpurchases. Whethersalesarerequiredtoreducethebalancesheetdependsonthedesiredreductionpacerelativetothematurityscheduleoftheholdings.TheFed'sassetpurchasesbeforetheCOVID-19pandemicweremostlyoflong-termdebt.AfterCOVID-19itboughtsecuritiesofvariousdurations,givingitselfmoreflexibilitytoreducethoseholdingsthroughrunoff. Treasuriesvs.MBS WhentheFedbuysdebtsecurities,thebuyingdrivesuptheirprice,therebyloweringtheyield.WhentheFedbuysTreasurysecurities,thereducedyieldproducesdebtinterestsavingsfortheU.S.government. Incontrast,whentheFedbuysMBS,theresultinginterestsavingsareeventuallypassedontohomebuyersintheformoflowermortgagerates.Homebuying,inturn,stimulatespurchasesofappliancesandfurniture,andsupportsalargehomebuildingindustry.Asaresult,reducedMBSyieldsstimulatetheeconomymoredirectlythanreducedTreasuryyields.ThesmallersizeoftheMBSmarketrelativetothatforTreasurydebtalsomeanstheFedcanmoveyieldsmoredramaticallyperdollarspent. ReductionsintheFed'sMBSholdingswilldirectlyaffectmortgagerates,andthroughthemthehousingmarketandthebroadereconomy.TheFOMC'sJanuary2022referencetolimitinglong-termholdingstoTreasuriessoasnottoaffecttheallocationofcreditacrosssectorsoftheeconomystronglysuggeststhat'sexactlytheeffectFedpolicymakersattributetotheFed'sMBSpurchases.TheunavoidableimplicationisthatatleastsomeattheFedfeelitcontributedtoanoverheatedhousingmarketin2021-2022. IftheFedmovesfromcappingreinvestmentinMBStooutrightselling,thehousingmarketislikelytofeeltheeffectintheformofevenhighermortgagerates. TheBottomLine TheshrinkingoftheFed'sbalancesheetshouldbeviewedasavictory,sinceonlyimprovementintheeconomy'sprospectsislikelytobringitabout.BecausetheFedcontrolstheU.S.currency,itsbalancesheetispracticallylimitedonlybytheavailabilityofassetsandtheFed'spreferencefornotusurpingmarkets'roleinsettingsecuritiespricesandallocatingeconomicresources. Byshrinkingthebalancesheet,theFedrunstheriskofreversingsomeofthebenefitsaccruedbyitsexpansion.Butiftheeconomyistrulyonthemend,it'slikelytoweathergradualchangeintheFed'ssecuritiesportfolio. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. BoardofGovernorsoftheFederalReserveSystem."TheEffectoftheFederalReserve’sSecuritiesHoldingsonLonger-termInterestRates." BoardofGovernorsoftheFederalReserveSystem."RecentBalanceSheetTrends." BoardofGovernorsoftheFederalReserveSystem."FactorsAffectingReserveBalancesofDepositoryInstitutionsandConditionStatementofFederalReserveBanks."Table5,Page6. FederalReserveBankofNewYork."FederalReserveAssetPurchases:ThePandemicResponseandConsiderationsAhead." BoardofGovernorsoftheFederalReserveSystem."FederalReserveIssuesFOMCStatement,Nov.3,2021." BoardofGovernorsoftheFederalReserveSystem."FederalReserveIssuesFOMCStatement,Jan.26,2022." BoardofGovernorsoftheFederalReserveSystem."PlansforReducingtheSizeoftheFederalReserve'sBalanceSheet." BoardofGovernorsoftheFederalReserveSystem."PrinciplesforReducingtheSizeoftheFederalReserve'sBalanceSheet." FederalReserveBankofDallas."Fed’sMortgage-BackedSecuritiesPurchasesSoughtCalm,AccommodationDuringPandemic." Reuters."SalesofFed'sMortgage-BackedSecuritiesMayBeFutureOption,WilliamsSays." CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. Provider Name Description RelatedArticles Mortgage HowtheFederalReserveAffectsYourMortgage FederalReserve UnderstandingtheFederalReserveBalanceSheet MarketsNews FedWillShrinkBalanceSheet'Rapidly,'BrainardSays EconomicNews FedRaisesRates50BasisPointsatMay2022Meeting GovernmentSpending HowDotheFed'sOpenMarketOperationsAffecttheU.S.MoneySupply? EconomicNews MarketsExpect50-Basis-PointFedRateHikeinMay2022 PartnerLinks RelatedTerms PortfolioRunoff Portfoliorunoffdescribesthedeclineofincome-producingassetsifproceedsfrommaturingsecuritiesarenotreinvested. more FedBalanceSheetDefinition TheFedbalancesheetisafinancialstatementpublishedonceaweekthatshowswhattheFederalReserve(Fed)ownsandowes. more WhatIsCreditEasing? Crediteasingisusedtorelieveamarketgoingthroughturmoil.Crediteasinghappenswhencentralbankspurchaseprivateassetssuchascorporatebonds. more CentralBankDefinition Acentralbankconductsanation'smonetarypolicyandoverseesitsmoneysupply. more LearnHowTaperingImpactstheEconomy,StockMarket,andInvestors. Taperingiswhenacentralbankreversesitsquantitativeeasing(QE)policies. more WhatIsAgencyMBSPurchase? "AgencyMBSPurchase"typicallyreferstotheU.S.FederalReserve'spolicyofpurchasingcertaingovernment-backedsecurities. more