The Federal Reserve said Wednesday that it will begin a multi-trillion-dollar balance sheet contraction in June that will drain liquidity from money markets for years to come.
Since March, the Fed has kept its balance sheet stable at nearly $9 trillion by reinvesting proceeds from maturing securities.
After a three-month ramp-up, starting in September, the Fed said it would allow a maximum of $95 billion to exit its portfolio without reinvestment each month. It will be $60 billion in treasury bills and $35 billion in mortgage-backed securities.
When the Treasuries cap is not reached, the Fed will allow Treasuries to exit its portfolio.
At this rate, the “quantitative tightening program” could shrink the Fed’s balance sheet by more than $1 trillion a year. The central bank has not set a target for the balance sheet.
The general market consensus is that the QT program could end in 2024 with a balance sheet below $7 trillion, said Ellen Gaske, chief economist at PGIM Fixed Income.
The Fed’s balance sheet doubled during the pandemic as the Fed bought assets, first to keep the US bond market operating stress-free, then to keep interest rates low and support growth.
Fed officials want balance sheet runoff to operate in the background — like “watching the paint dry” in the words of Philadelphia Fed President Patrick Harker. Another way of thinking is like indoor plumbing. You don’t think about it until it doesn’t work.
Economists say that’s what happened when the Fed reduced its balance sheet in 2017-2019 – – all was quiet until it was no longer the case.
There have been periodic episodes where markets have been spooked by the feeling that too much liquidity has flowed out of the system. In September 2019, the Fed finally had to stop shrinking the balance sheet and reverse the trend.
In this cycle, one of the keys to the markets is when the Fed could sell some of its mortgage holdings for $2.7 trillion. This will trickle down to US debt markets.
Fed officials only said they would consider selling MBS once the balance sheet liquidation is well under way. “A decision by the FOMC to implement an agency MBS sales program would be announced well in advance,” according to the minutes of the Fed’s March meeting.