How the Federal Reserve could shrink its balance sheet by nearly $9 trillion as it battles inflation

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Slimming down might be the trickiest part after two years of a pandemic.

According to Edward Al-Hussainy, a senior interest rate strategist at Columbia Threadneedle Investments.

“At the height of the pandemic, the Fed injected billions of dollars into the financial system through asset purchases to support markets and the broader economy,” Al-Hussainy wrote in a client note. Tuesday.

Its monthly TMUBMUSD10Y treasury bond purchase program,
1.853%
and MBB agency mortgage-backed securities,
-0.28%
worked as expected, keeping financial markets flooded with liquidity and asset prices low, as the central bank’s balance sheet exploded (see chart).

Federal Reserve balance sheet stands at nearly $9 trillion

Columbia Threadneedle Investments

Now comes probably the hardest part.

Fed Chairman Powell has been focused on designing a ‘soft landing’ from full support for the economy, with the central bank’s first interest rate hike since 2018 being likely next week at his two-day policy meeting. Going forward, the Fed plans to further withdraw its easy money policy by reducing its holdings, with the aim of bringing inflation closer to its annual target of 2%, down from 7.5% in January.

The path could be complicated by soaring prices for oil and other commodities in the wake of Russia’s unprovoked invasion of Ukraine two weeks ago, resulting on Tuesday in the Biden administration banning Russian imports oil, liquefied natural gas and coal.

Read: Biden bans Russian oil imports following Ukraine invasion as he warns gas prices will rise further

Additionally, the chart above shows that investors and the Fed have yet to experience a period of significant balance sheet reduction.

As Al-Hussainy said: “We have a good idea of ​​how the expansion of the balance sheet
works when the economy is in trouble. But our understanding “is less clear” when the Fed shrinks its balance sheet, in part because that would typically happen in a growing economy. The pandemic also interrupted his previous attempt.

He now sees three avenues for the Fed to reduce its holdings, not all of which should add to market turbulence:

  • Runoff: Since last summer, Fed officials had been preparing to slow the $120 billion in monthly pandemic-era bond purchases, with March set as the target end date. The Fed can now choose to “do nothing,” Al-Hussainy said, since the Fed has focused on buying shorter-term bonds. “With about a quarter of the balance sheet maturing in 2½ years, this would shrink the balance sheet by simply allowing assets to organically retire as debt matures.”

  • Change what you own: The housing market has become hot and potentially dangerous in some parts of the country during the pandemic. The Fed “would very much like to exit the agency MBS market altogether,” according to Al-Hussainy, and it may choose to reduce its exposure to the sector over time.

  • Sell ​​longer-term bonds: The Fed could also sell longer-term Treasury bonds that mature in seven to 20 years, using the proceeds to buy shorter-term debt to help steepen the yield curve. Or he could sell 15-30 MBS, though he hasn’t tried either before, and those moves “would be seen as quite disruptive.”

Even so, Al-Hussainy tells investors to keep an eye on what the unwinding trajectory signals in terms of future increases in the short-term federal funds rate, “which would have the most direct impact on holdings. fixed income”.

SPX US Stocks,
-0.72%
rose on Tuesday, a day after the Dow Jones Industrial Average DJIA,
-0.56%
entered correction territory for the first time in two years, marking a decline of at least 10% from its peak. The Nasdaq Composite also fell into a bear market, down at least 20% from its recent all-time high.

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