E Aside From Raising Interest Rates, Will The Fed Decide To Shrink Its Balance Sheet?

Since the beginning of the financial market meltdown in August of 2007 the U.S. Federal Reserve’s balance sheet has increased enormously. The total assets of the Fed increased from $869 billion on August 8, 2007 to $4.45 trillion as of February 13, 2017.

The Fed expanded its balance sheet during and after the financial crisis by purchasing large quantities of Treasuries and mortgage-backed securities. The composition change in the balance sheet was largely related to the Fed’s support of the mortgage granting institutions to contain the collapsing housing sector.

As the following two charts illustrate, the total assets at the Fed have been relatively constant at the current $4.4 trillion level since the end of the last quantitative easing phase (Q3).

Recently, after a decade of highly expansionary monetary policy, the Fed has begun to raise interest rates and a process of normalization is under way. The Fed’s clear intent is to gradually increase the federal funds rate up to more normal levels, since the slowly growing American economy is close to full employment and inflation seems to be trending close to the Fed’s 2% target.

The normalization process will involve further federal funds interest rate hikes and could, at some point, also involve a decision to gradually shrink the size of the Fed’s balance sheet.

The reduction in the size of the balance sheet is a somewhat less discussed monetary tightening option, though there have been some comments from investors wondering if this approach is also on the table.

We tend to think that the Fed could accomplish its normalization objectives without shrinking the balance sheet.

But if the Fed wants to tighten monetary policy faster and more effectively, then shrinking the balance sheet is the way to go. That is, the Fed could raise interest rates faster and further out along the Treasury yield curve by shrinking the size of its balance sheet.

In other words, shrinking the balance sheet and shifting the composition of its assets back more heavily to Treasury securities offers a series of subtle options.