The Federal Reserve on Wednesday said that in June it will start a multi-trillion dollar balance sheet contraction that will drain liquidity from the money markets for years to come.
Since March, the Fed has been holding its balance sheet steady at nearly $9 trillion by reinvesting proceeds of maturing securities.
After a three-month runup, beginning in September, the Fed said it will allow a maximum of $95 billion to roll off its portfolio without reinvestment each month. This will consist of $60 billion of Treasurys and $35 billion of mortgage backed securities.
When the cap on Treasurys isn’t reached, the Fed will allow Treasury bills to run off its portfolio.
At that pace, the “quantitative tightening program” could reduce the Fed’s balance sheet by over $1 trillion a year. The central bank hasn’t set a target for the balance sheet.
The market generally consensus is that the QT program could end in 2024 with a balance sheet under $7 trillion, said Ellen Gaske, lead economist at PGIM Fixed Income.
The Fed’s balance sheet doubled during the pandemic as the Fed bought assets, first to keep the U.S. bond market functioning without stress and later to keep interest rates low and support growth.
Fed officials want the balance sheet runoff to operate in the background – like “watching paint dry” in the words of Philadelphia Fed President Patrick Harker. Another way to think of it is like indoor plumbing. You don’t think about it until it doesn’t work.
Economists say that was what happened when the Fed reduced its balance sheet in 2017-2019 – – everything was calm until it wasn’t.
There were periodic episodes where markets got spooked over a sense that too much liquidity had drained out of the system. In September 2019, the Fed eventually had to stop shrinking the balance sheet and reverse course.
In this cycle, one key to markets is when the Fed might actually sell some of its holdings of mortgages $2.7 trillion. This will ripple out through U.S. debt markets.
Fed officials have said only that they would consider MBS sales after the balance sheet runoff was well underway. “An FOMC decision to implement a program of agency MBS sales would be announced well in advance,” according to the minutes of the Fed’s March meeting.