Must-know: How the Fed may deal with its bloated balance sheet

Market Realist

Why the Fed is testing new monetary policy tools (Part 3 of 5)

(Continued from Part 2)

The extraordinary stimulus

The magnitude of the great recession prompted the Fed to use extraordinary measures to boost consumption growth and investments. The Fed has maintained the Fed funds rate near zero since 2009. Since the Fed couldn’t reduce the Fed funds rate any more, it started with the asset purchase program to provide additional liquidity to the markets. The current phase of the asset purchase program, QE3, started in October, 2012. Originally, the Fed purchased $85 billion worth of securities ($45 billion long-term Treasury securities and $40 billion mortgage-backed-securities) a month. Eventually, after seeing an improvement in the economy, the Fed tapered the asset purchase program four times since December, 2013, by $10 billion each time. The asset purchases currently stand at $45 billion a month. The taper is expected to continue at $10 billion a month. At the current pace, the taper should end this fall.

The Fed’s balance sheet size has bloated to $4.3 trillion as on May 14, 2014, compared to pre-crisis level of $870 billion seen on August 1, 2007. This includes $2.4 trillion in U.S. Treasury securities (TLT) and $1.7 trillion in mortgage-backed-securities (MBB).

As the asset purchase program winds down and the Fed readies for “normalization” in monetary policy, the biggest question would be “How will the Fed scale down the size of its balance sheet?”

Dr. Dudley said that “the balance sheet will be set on auto pilot,” meaning the securities will go off the balance sheet once they mature. This means that the Treasury securities will go off the balance sheet at maturity and the mortgage-backed-securities will go off the Fed’s balance sheet as and when mortgages are paid off. There won’t be an outright sell-off of any security during the normalization process. As a result, adjusting the Fed funds rate would be the primary tool available with the Fed to tighten the monetary policy.

The interest rates will increase during the process of tightening which will lead an to increase in Treasury bond (BND) yields. Corporate bond yields are usually derived from Treasury yields, the yields on investment grade bonds (LQD), and high-yield bonds (HYG). However, the magnitude of the increase in yields on corporate bonds might be lower than that for Treasury bonds because the improving economy will lead to improved corporate performance and result in the narrowing of credit spreads. However, our readers should be aware that the credit spreads are already running at their all-time lows.

To learn about what tools the Fed intends to use to control money market rates, continue reading the next section of this series.

Continue to Part 4

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