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Fed’s balance sheet reduction and its implications, explained

Fed’s balance sheet reduction and its implications, explained

Fed’s balance sheet reduction and its implications, explained
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By Yashi Gupta  Jan 17, 2022 12:25 PM IST (Updated)

In the wake of the COVID-19 pandemic, US Federal Reserve's balance sheet has ballooned as the Fed tried to avert an economic meltdown by pumping money into the system. Consequently, the Fed’s balance sheet jumped from $4.7 trillion in March 2020 to over 7.6 trillion by March 2021. Now the Fed is gearing to shrink its balance sheet. But what does balance sheet shrinking mean? And how can it impact the markets? Here's everything you need to know

The US Federal Reserve meeting minutes have shown that the central bank is gearing up to reduce the size of its balance sheet. The balance sheet had ballooned as the Fed tried to avert an economic meltdown in the wake of the COVID-19 pandemic by pumping money into the system.

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The Fed, the world’s largest central bank, holds bonds worth over $8 trillion, more than double what it owned back in 2020. It now feels the stimulus is no longer required as the job market is close to full employment, and inflation is rising.
The Fed’s balance sheet
Central banks like the Federal Reserve also maintain balance sheets detailing all assets and liabilities. Their balance sheet changes whenever they take steps to meet goals – promoting employment, controlling inflation, and managing long-term interest rates.
Assets: Fed’s assets include the government securities (G-secs) and the loans it has given to the regional banks. G-secs, including Treasury notes and bills, make up 60 percent or $5 trillion of the total assets. The maturity dates of T-notes range from 2-1o years and that of T-bills range from 4 to 52 weeks.
Mortgage-backed securities (MBS)—a basket of home loans—also make up Fed’s assets. As of March 17, 2021, the Fed owned over $2 trillion in MBS. They are securities packaged by banks and other financial institutions and sold to investors.
The interest Fed charges on loans given to banks also make up its assets. Additionally, the assets it buys under the open market operations (OMO) also come under the asset section. OMOs are events when the Fed buys or sells US Treasury securities in the market to control the money supply in the system. When it buys bonds, it releases money into the system, and when it sells bonds, it sucks money out of the system.
The Fed extends loans to banks via a repo window and discount window, and charges banks a rate of interest called the federal discount rate.
Liabilities: The US dollars in circulation is Fed’s liability. And so is the money in the reserve account of member banks and depository institutions. The Fed’s liabilities as of March 2021 totalled nearly $7.65 trillion, with $2 trillion in currency and $5.3 trillion in deposits.
In the wake of the pandemic, Fed purchased assets to increase the money supply while keeping interest rates low. Consequently, the Fed’s balance sheet jumped from $4.7 trillion in March 2020 to over 7.6 trillion by March 2021.
How will the Fed reduce the size of its balance sheet?
While the Fed has not finalised how it wants to reduce the balance sheet, the minutes have shown it wants to carry out a “rapid reduction” after hiking the interest rates. It has two ways to do it: selling securities or ceasing to reinvest in maturing securities.
However, Fed wouldn’t outright reduce the size of the balance sheet. It would first rather reduce the pace of buying the bonds, thereby reducing the pace of expansion of the balance sheet, a process known as tapering. Tapering is a controlled way in which central banks phase out QE so they don’t shock the economic recovery.
The Fed has already begun tapering. In November and December, its monthly purchase of Treasuries was down by $10 billion, and MBS purchases were down by $5 billion.

Also Watch | How serious can be Fed tapering for Indian macros?

Fed can use two methods to reduce the size of the balance sheet:
Selling securities: Selling securities on the balance sheet is one way to go. But the Fed is unlikely to take this route. One, selling securities puts pressure on the bond market, increasing interest rates. This could lead to volatility in financial markets.
Former Fed Chair Ben Bernanke had once said that he was worried about “attempts to actively manage the unwinding process” as that could “lead to unexpectedly large responses in financial markets.”
In 2013, the mere announcement of tapering had caused panic selling in the US treasury markets, sending interest rates surging. That event is now referred to as the taper tantrum.
Ceasing purchases: Another way is to let the balance sheet decline by not reinvesting the principal. Bernanke had argued Fed keep its balance sheet permanently large. One way to do this is to let the securities mature over time.
Why are Fed’s holdings important?
Fed’s bond holdings are considered a key element in keeping interest rates low while boosting financial markets. It increases the flow of money in the economy by making borrowing cheaper.
By buying government debt and MBS, the Fed reduces these bonds’ supply in the market. Private investors who want to own these securities then hike the prices of the remaining supply, lowering their yield (bond prices and yields move oppositely).
Due to this phenomenon, even when short-term interest rates are near zero, the longer-term rates remain high. It gives Fed the space to make more purchases to stimulate the economy.
Treasury yields act as a benchmark for interest rates. Low treasury yields translate into lower rates, making it easier for households to take a house or car loan and businesses to focus on hiring and equipment buying. It creates an illusion of wealth for households, driving spending and spurring the economy.
In the event that analysts see a change in the balance sheet that could portend tapering, it is viewed as a warning that monetary policy is likely to tighten.

How is this balance sheet reduction different from the previous ones?
This time, balance sheet reduction would be a faster process. Because the central bank has greater confidence in the economic recovery.
Fed minutes show many officials think the pace of reductions should be accelerated this time. Officials want to be able to respond to inflation, which is 2 percent above plan. Furthermore, the labour market is showing encouraging signs of improvement, convincing the Fed that the goal of full employment is within reach.
What are the implications of Fed’s balance sheet reduction?
The Fed’s guidance for a tighter monetary policy, while inevitable, has made financial markets jittery. Real yields—inflation-adjusted Treasury yields—surged to levels not seen in the last two years. Investment decisions are based on real yields for all assets – bonds and stocks, alike. Rising yields impact every corner of the market.
Reuters report said: “Any action to increase or decrease the assets and liabilities held by the Fed can significantly impact all consumers and businesses in the United States.”
Besides, liquidity flows into emerging markets too could shrink causing asset prices to shrink in those economies. While extending monetary stimulus, the aim of central banks is to help the home economy. However, a big chunk of that money finds its way into risk assets overseas. Once this source of money dries up, equity, bond and even commodity prices could come under pressure.

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