Why reducing the Federal Reserve’s balance sheet matters


Wednesday’s release of the minutes of the Federal Reserve’s March 15-16 policy meeting sparks widespread discussion of the central bank’s plans to shrink its bloated $9 trillion balance sheet. There will obviously be implications for the economy and financial markets, but exactly what they will be cannot yet be determined with sufficient confidence. Of course, that will take time. Accordingly, here are some key questions to ponder over the coming weeks:

There’s a simple yet insightful way to think about why and how reducing the Fed’s balance sheet matters.

Imagine that you are planning to buy a house and you learn that the owner of many houses in the neighborhood is planning to sell them. Imagine this owner doubling the number of homes he owns in the last two years alone, buying them without worrying about price and value. And imagine the owner will be just as price insensitive by letting them go over time.

I suspect you would think more seriously about whether to buy your home now. Indeed, you would need a stronger reason to do so given concerns about valuations in the face of a large, persistent, non-commercial seller.

This is the situation facing the fixed income market now that the Fed has signaled that it plans to gradually and steadily shrink its balance sheet at the rate of about $1 trillion a year.

A definitive plan has yet to be announced, and even when such a plan is in place, changes could be made to the size, pace, and balance between passive (maturities) and active (sales) outflows. . And the fallout from such a plan is complicated by the fact that the Fed will simultaneously raise interest rates.

This is not just any rate hike cycle. With the Fed already well behind the inflation curve, a growing number of Wall Street analysts have raised their forecasts to include several 50 basis point moves. The terminal rate is also rising, adding to concerns that now that it’s being forced primarily by its own decisions and the mistakes of inflation to scramble and play catch-up, the Fed could end up pushing into a recession a economy which, for too many years, has been conditioned to live with rates close to zero and large injections of liquidity.

The absolute impact is clear. By reversing its role as a large, regular, non-commercial buyer of government bonds, the Fed is ending its protracted ultra-loose liquidity regime that has severely suppressed yields across the government bond complex. State. As a stand-alone price influence, the impact could be quite pronounced given that the direct impact is heightened by the likelihood that other actual and potential holders of the securities the Fed intends to cut will adapt their behavior.

While the short-term direction of yields is clear – segments of the curve steepened on Thursday, with 10- and 30-year yields hitting their highest level since 2019 – the size and timing of future moves are much more difficult. to be determined. The uncertainty relates to other influences on government bond yields, including developments in the real economy.

Even more interesting is the relative impact.

So far, most of the other sub-asset classes within the fixed income complex have handled higher and more volatile government yields relatively well. What remains uncertain is whether this continued volatility in returns will destabilize other risk factors such as credit, liquidity and market functioning.

If that happens, equities could also be affected after benefiting greatly from Fed-induced conditioning that has made valuations a function of TINA (there is no alternative to equities), FOMO (fear of missing out another up move for stocks) and, therefore, BND (buy the dip, whatever the cause).

The impact on the economy

Traditionally, higher yields have influenced the real economy through three channels: affordability, wealth and risk sentiment.

The effects of the affordability channel, which are traditionally transmitted first and foremost through housing and the automobile, will this time be moderated by supply disruptions in the automobile industry. Similarly, they will be tempered for companies as they have taken advantage of ultra-accommodative financial conditions to extend their debt at low cost and reduce their carrying costs.

The indirect effects for both, however, will be significant given the growing number of households and businesses facing rising costs, particularly due to high food and energy prices.

The wealth effect is something more uncertain. Without a doubt, years of very accommodative monetary policy have pushed asset prices ever higher. The immediate reversal, however, is also a function of the extent to which investors are willing to think about absolute risks and not just relative risks.

This is linked to the general feeling of risk. There will likely be some erosion, but the pace and extent will largely depend on what happens in the country’s dynamic labor market.

Even this narrow analysis of the effects of quantitative tightening highlights the multifaceted and fluid nature of the Fed’s paradigm shift in liquidity. While significant uncertainties remain, there are also clear lessons at this early stage: Fed balance sheet reduction is likely to have consequences, the broad contours of where the effects will be felt are clear. , but the specific scale and timing are impossible to determine. pin now with a high degree of certainty.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is President of Queens’ College, Cambridge; Chief Economic Advisor at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO; and President of Gramercy Fund Management. His books include “The Only Game in Town” and “When Markets Collide”.

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