Fed Likely to Begin Cutting Back $4.5T Balance Sheet This Year

Before the end of this year, the Federal Reserve will likely begin paring back the $4.5 trillion balance sheet it amassed as it attempted to prop up the U.S. economy during the recession, yet another sign of the U.S. economy’s continued progress since the financial crisis.

Minutes of the Fed’s March policy meeting, released Wednesday, contained details of the central bank’s first intensive discussion of how to unwind its massive balance sheet. The minutes showed that Fed officials mostly preferred to tie the change to the strength of the economy, and to gradually phase out reinvestments of the proceeds from the Treasury and mortgage-backed securities that mature, rather than suddenly ceasing reinvestments altogether. That would allow the Fed’s balance sheet to gradually run down in a process that is likely to take years.

“Provided that the economy continued to perform about as expected, most participants anticipated that gradual increase in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year,” the meeting minutes read.

“I think the operative word here is going to be gradual. They’re not going to want to go cold turkey,” said Josh Feinman, global chief economist for Deutsche Asset Management. “They don’t want to do anything disruptive.”

The U.S. central bank has already begun the process of raising interest rates back to more normal levels, after holding them near zero for years to buoy the economy during the financial crisis. The U.S. job market continues to strengthen, and business and consumer confidence have spiked in recent months. In March, the Fed raised its benchmark interest rate for the second time in a year and said it expects two more rate hikes this year and three more next year.

Yet the Fed has yet to begin significantly reducing the massive amount of Treasurys and mortgage-backed securities it purchased during the financial crisis to try to spur lending and keep interest rates low. Some observers argue that these holdings are weighing on long-term interest rates, and that the Fed should not intervene so heavily in the markets.

As the U.S. economy continues to gather strength, the Fed aims to gradually remove its support and let the economy stand on its own. If the Fed sells off its holdings too quickly, that could trigger a sudden drop in the price of those assets or an increase in interest rates, potentially upsetting markets.

Most economists believe the U.S. economy is strong enough to sustain gradual increases in the interest rate, and that the Fed should now shift its focus to restraining emerging inflation.

The minutes of the March meeting showed that Fed officials are keeping a closer watch on inflation but don’t yet believe it is meeting their 2 percent target on a sustained basis. Fed officials have argued that the recent recovery in oil prices appears to be driving increases in inflation, and that energy prices can fluctuate significantly.

The federal government is set to release its official data on employment on Friday. Strong data could encourage the Fed to announce another rate hike at its upcoming June meeting.

Before the release of the minutes on Wednesday morning, the futures market was forecasting a 4 percent probability of a rate hike in May and a 63 percent probability of a hike in June.

The minutes from the Fed’s March meeting showed continued uncertainty about how the White House’s policies would affect the economy, with only about half of the Fed’s voting members incorporating assumptions about fiscal policy into their economic projections.

“Several participants now anticipated that meaningful fiscal stimulus would likely not begin until 2018,” the minutes read. “. . . some participants and their business contacts saw downside risks to labor force and economic growth from possible changes to other government policies, such as those affecting immigration and trade.”

The minutes showed that the Fed is increasingly encouraged by progress in the global economy, including stronger growth in China and in Europe. However, officials pointed to upcoming elections in Europe, which could trigger the exit of more countries from the Eurozone, as a possible risk to the global economy.

At the March news conference after the Fed’s policymaking committee announced the rate hike, Fed chair Janet Yellen emphasized that the committee wants to use changes in the short-term interest rate target as its main tool for influencing monetary policy, not the balance sheet. The balance sheet is “not a tool that we would want to use as a routine tool of policy,” she said.