To help stabilize the financial system and promote economic recovery, starting in late 2008 the Federal Reserve purchased large quantities of financial assets, primarily Treasury securities and U.S. government-backed, mortgage-related securities.
The policy of so-called quantitative easing (see here and here) expanded the Fed’s balance sheet from less than $900 billion before the crisis to about $4.5 trillion today—including about $2.5 trillion in Treasuries and $1.8 trillion in mortgage-related securities. The Fed stopped buying large quantities of assets in October 2014. Since then, it has kept the size of its balance sheet constant, buying just enough to replace maturing securities.
Beginning in late 2008, the Fed began large-scale purchases of assets such as U.S. treasuries and government-supported mortgage-backed securities (MBS) to stave off a complete collapse of the financial system. For six years, the Fed embarked on this asset purchase program — known as quantitative easing — which kept interest rates at record-low levels in the hope increased bank lending would spur growth. The effectiveness of the program will never really be known (a counterfactual scenario in which there never was QE cannot be tested), but the financial system in the U.S. did survive a scare of historic proportions. Some will argue QE went on for too long, leading to overinflated asset prices, but we leave that debate for another day. (See also: Understanding the Fed’s Balance Sheet)
On October 29, 2014, when Fed Chair Janet Yellen announced the end of the bond-buying program, the Fed’s balance sheet had reached $4.48 trillion. By reinvesting principal payments and maturing securities, the balance sheet has remained at or about $4.5 trillion since. According to weekly data published by the Fed, its balance sheet consists of $2.5 trillion in treasuries and $1.8 trillion in mortgage-backed securities.
As economic conditions continue to improve, evident in the labor market and rising inflation, the Fed faces growing pressure to address its balance sheet. In December, the Fed stated it would not begin the process of shrinking its balance sheet until “normalization of the level of the federal funds rate is well under way.” When that will be, or more importantly, at what level Fed officials believe normalization is underway remains unknown. Putting this subjective notion aside, when the Fed does begin to reduce its balance sheet, it will do so in one of two ways. It can sell securities on its balance sheet, or it can choose not to reinvest maturing securities.
Until the election of Donald Trump the chances of the Fed actively selling securities to reduce its balance sheet was unlikely. Under this scenario — a more aggressive path of balance sheet reduction — selling securities would put pressure on the bond market, which could cause interest rates to increase rapidly, leading to unwanted volatility in financial markets. However, the election of Trump could see a shake up of the Fed board. Trump has been highly critical of Yellen and the Fed’s low interest rate policy and if he chooses to shake up the Fed it could shift the strategy of the central bank. “This could be important for balance sheet policy because many Republican-leaning economists have criticized quantitative easing and have expressed a preference for rapid balance sheet rundown, perhaps even through asset sales,” Daan Struyven, a Goldman economist said, via CNBC. (See also: How Trump Could Quickly Shake Up the Fed)
In a January blog post titled “Shrinking the Fed’s balance sheet,” former Fed Chair Ben Bernanke warned against the Fed actively trading its balance sheet. “I worry though that, in practice, attempts to actively manage the unwinding process could lead to unexpectedly large responses in financial markets,” Bernanke said. The unexpected responses being a second taper tantrum.
In May 2013, the Fed announced it would taper back its $70 billion-a-month bond-buying program. The announcement caused panic selling in U.S. Treasury markets as interest rates surged higher. The day became known as the taper tantrum.
Maturing, the Mature Approach
By simply letting the balance sheet slowly decline by not reinvesting the maturing assets it would signal a clear path for the reduction in the balance sheet. While the Republicans argue that the pace of reduction should be swift, it is worth noting that $1.4 trillion of the $2.5 trillion in Treasuries have maturities of less than five years. Additionally, if the Federal Reserve is to keep its balance sheet large permanently — something Bernanke has argued for — the short duration of these securities makes the argument for letting the assets mature over time the more mature and stable approach.
The Bottom Line
The combination of a new president and an improving U.S. economy has bought the balance sheet back into play. A highly critical Republican government that will likely replace Fed Chair Janet Yellen and Vice Chair Stanley Fischer in early 2018 looks set to put focus on the balance sheet. With the rumblings from the right, the Fed is looking to get ahead of the game, which at this stage looks set to begin at the end of 2017.