Fed balance sheet… The Fed will start to shrink its balance sheet as of the May meeting. FOMC minutes stirred things up as committee members agreed that high inflation and tight labor market balance sheet reduction would soon begin. The monthly upper limits for the Treasury and MBS runoff are likely to reach $60B and $35B, respectively, and to be phased in in just three months. The accelerated timeline has helped flatten the yield curve.
Technical details of the balance sheet reduction… The acceleration in the balance sheet decline coincides with a hawkish change in tone when it comes to interest rate hikes. On the pace and composition at which the Fed is likely to lower its balance sheet of about $9T, there will be monthly caps of $60 billion and $35 billion, respectively, for Treasury and mortgage-backed securities (MBS) due. This balance sheet reduction will be almost double the 2017-2019 experience.
When we compare the facts such as bank reserves, asset and liability structure, sales from the balance sheet with the 2015 model tapering; At that time, the overnight reverse repo (ON RRP) facility was quite small (less than $200 billion for most of July 2017). Today, by contrast, purchases at the ON RRP facility are much larger (over $1.5 trillion for most of 2022).
Fed System Open Market Account Domestic Securities… Source: New York Fed
MBS sales may be on the table, with the FOMC choosing to hold Treasury securities primarily over the long term. The Fed's balance sheet will shrink by about $1 trillion this year. Powell said the contraction in the balance sheet "could be equivalent to another rate hike". The asset side of the Fed's balance sheet is predominantly composed of Treasury securities and mortgage-backed securities (MBS), while the liabilities side consists mainly of money in circulation, bank reserves held at the Fed, and the general account used by the US Treasury. The balance sheet contracted organically once the impact of most of the Fed's non-traditional loans that occurred earlier in the pandemic, such as central bank swaps and corporate bond purchases, but bond purchases steadily increased its portfolio of assets.
When Treasury securities held by the Fed become due, when the Fed does not reinvest the proceeds of those securities and the Treasury does not issue new securities, the Fed holds fewer assets (Treasury securities decrease) and has fewer liabilities (the cash the Treasury holds at the Fed). decreases), thus reducing the size of its balance sheet. At the end of this process, the Fed's balance sheet size will shrink as Treasury securities decrease on the asset side and reserves on the liabilities side.
Conclusion? The accelerated pace of balance sheet flow coincides with the FOMC continuing full throttle to raise the fed funds rate. The main expectation is that the FOMC will raise 50 basis points in both May and June meetings. The Fed's balance sheet declines as the Fed does not reinvest the proceeds of Treasury securities that are due. On the liabilities side of the Fed's balance sheet, the decline may be due to reduced reserves held by banks or a reduction in the purchase of ON RRP, or a combination of both.
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