The Fed’s plan to shrink its balance sheet, quickly

What’s behind the faster pace of quantitative tightening?

The Fed plans to reduce its $8.5 trillion balance sheet beginning June 1, when it will no longer reinvest proceeds of up to $30 billion in maturing Treasury securities and up to $17.5 billion in maturing agency mortgage-backed securities per month. Beginning September 1, those caps will rise to $60 billion and $35 billion, respectively, for a maximum potential monthly balance sheet roll-off of $95 billion.

The Fed ended bond purchases only in March 2022, so this tightening is occurring considerably sooner than in the last reduction cycle. After the global financial crisis, the Fed ended quantitative easing purchases in 2014 but didn’t start to reduce its balance sheet until 2017. The maximum roll-off then was roughly half of that expected this time around.

Three key factors explain today’s faster pace:

• The Fed’s balance sheet is significantly larger this time relative to what would be considered an optimal range to effectively implement monetary policy.
• The economy is at a more advanced stage of the business cycle and running hotter, as reflected in a smaller output gap, lower unemployment, and higher inflation than in 2014.
• The Fed is likely less uncertain now about how markets and financial conditions may react given that it has at least some experience in communicating and executing roll-off plans.

Why interest rates will remain the Fed’s primary tool

What likely won’t change is the Fed favoring the policy rate as its primary tool to effect policy, with balance sheet reduction running in the proverbial background to maximize predictability and minimize market disruption. That, along with concerns that balance sheet reduction would lead to much higher interest rates at the long end of the yield curve, is why the Fed set monthly caps for letting bonds mature passively rather than planning to actively sell securities from its portfolio.

Another consideration relates to the eventual terminal size of the balance sheet in terms of ensuring adequate market liquidity and carrying out monetary policy, which would serve as a guide for when the Fed would end asset roll-off. At present, this terminal size is uncertain. However, as shown in the graphic using simplifying assumptions, Vanguard estimates that the balance sheet may settle around 18% of GDP, or just above $5 trillion, before the Fed begins winding down and eventually ending its roll-off, at which point it will allow its assets to grow in relation to the size of the economy. “That level could be reached around the end of 2025, barring any pauses or significant deviations from the currently communicated plan,” Hirt said.