Should we be worried by the fact that the Fed is reducing its balance sheet? David Buckle from Fidelity is one of those who think not; moreover, he believes that it won’t have any impact on the financial markets.
In the minutes of its last meeting, the Fed alluded to cutting back on its holdings of bonds purchased within the framework of its quantative easing programme. The institution has nothing to gain by surprising the market when it trims its excess reserves, but much to lose if volatility hits bond yields.
The Fed knows it’s a very sensitive subject. It is still lamenting the damage inflicted by the strong recovery in yields – the famous taper tantrum – when it announced it would reduce its balance sheet’s expansion.
The Fed’s changeable tools
The Fed’s system of buying and selling Treasury bonds in the market- operations in the open market – functioned until the institution embarked on its quantative easing programme, buying more Treasury bonds than it needed to balance out the reserves system, as reported by Buckle. Currently, there is a situation of excess reserves and the banks don’t need to adjust their reserves on a daily basis to comply with the minimum required, which invalidates the effective rate of the Fed funds.
As a result, transactions in the open market cannot now maintain the effective Fed funds’ rate exactly on target, the reason for which the FOMC now expresses its target rate as a range, currently at 0.75%-1%. From Fidelity, David Buckle explains:
Faced with an excess of reserves, the Fed has had to use other tools to ensure the banks are still prepared to mutually lend their reserves. For this reason, it has hiked the rate on the reserves’ excess, placing it at the top end of the range of the Fed funds’ objective. After the quantitative easing, the interest rate on reserves’ excess has become the target rate.
Will the Fed sell bonds to reduce its balance sheet?
Treasury bonds pay coupons and have a maturity date. To maintain its balance, the Fed has to reinvest these coupons and the principal payments, and this is what it has been doing. When the time comes to reduce its balance, it can sell bonds or stop reinvesting.
This is what has been worrying the market. Is the Fed about to start selling bonds?
I believe that the probability of this is virtually zero, given that the connotations would be very negative for the bond market. And the Fed agrees. According to the minutes, the FOMC members agreed that the decrease in investments in Federal Reserves securities should be gradual and predictable, and put in practice mainly by means of the progressive reduction in the reinvestments of the principal of these securities.
But when will this happen? Perhaps 2017 is too soon for the Fed to change its reinvestment policy?
The Fed’s balance sheet is currently valued at 4.5 trillion dollars. In 2017, around 160 billion dollars will mature, which I believe will be reinvested. In 2018, 430 billion dollars will mature, which will allow the Fed to reduce its balance sheet at a rate of up to 35 billion dollars a month. The bonds which mature in the next five years total 1.3 trillion dollars, which implies a reduction of up to 20 billion dollars a month. Fidelity’s expert concludes:
To me that seems a perfectly sensible reduction rate, which would trim the balance sheet by 70% in 2022. Obviously, the Fed could cut its balance sheet more slowly, reinvesting coupons and principals. If it wanted to reduce it more quickly, then it would have to sell bonds.
There is no real urgency to drain the excess of reserves, apart from allowing the new activities of operations in the open market to finish first. But these activities are being monitored closely by the Fed, and in the latest minutes it confirmed they are functioning correctly. They are also being successfully used by other big central banks as a monetary policy tool. Given that they seem to be working well, the Fed is considering maintaining this focus. In this case, it will have to maintain a hefty balance sheet and won’t need to cut it by much at all.