In March, the Federal Open Market Committee (FOMC) signaled it could begin shrinking the Fed’s balance sheet sometime later this year. However, with limited official details about what that means and none forthcoming from last week’s FOMC press release, many questions remain:
- How will the Fed decide exactly when to begin shrinking its balance sheet, and will the move be data or date dependent?
- Once the wind-down begins, how rapidly will the balance sheet shrink and to what new normal level?
- How will the Fed dispose of its assets: by simply refraining from reinvesting the proceeds from maturing securities, passively shrinkage the balance sheet, or by actively disposing of some assets to ensure a smoother path for balance sheet reduction?
- And would asset sales, should they occur, include both mortgage-backed securities (MBS) and Treasuries or would the Fed initially focus on a single asset class?
Back in September 2014, the FOMC released its Policy Normalization Principles and Plans (henceforth “the Framework”), its official statement outlining a three-step normalization strategy, including balance sheet reduction. First, the Fed would raise policy rates[1] to “normal levels.” Second, the Fed would begin to shrink the balance sheet in a “gradual and predictable manner” by ending the reinvestment policy. And third, the wind down would continue until the Fed holds only enough securities to conduct monetary policy “efficiently and effectively” with a portfolio consisting primarily of Treasuries. There is, of course, a caveat that the Fed can deviate from the Framework as economic conditions change. Since December 2015 the Fed has raised policy rates three times, but it has yet to update the Framework to provide further details on the next steps for balance sheet normalization.