The Federal Reserve could have a surprise in store for
investors this week, even if everyone already knows the central bank is raising
Along with the quarter-point increase in the Fed's benchmark short-term
target, the policymaking Federal Open Market Committee is likely to announce
another change that would signal an early exit from its history-making program
to reduce the level of bonds being held on its balance sheet.
The mechanics are a little complicated. Yet it suggests that what once
appeared to be an operation to shrink the amount of bonds the Fedowns that
would have run well into the next decade could be wrapped up next year, or
early 2020 at the latest.
Instead of reducing the balance sheet from its peak of $4.5 trillion to
$2.5 trillion or so as some Fed officials indicated, the impact could be far
less — perhaps, some suggest, to $3.5 trillion or even a little more.
It all depends on how tight financial markets get. Tightening in the
money markets, and an unexpected push of the fed funds rate toward the high end
of its target range, would be key factors in prompting the Fed to re-examine
its policy normalization efforts from financial crisis extremes.
If the balance sheet runoff ends sooner then anticipated, investors
probably can expect that the rate-hiking cycle could wrap up a bit earlier as
"There is a very active debate, and it's probably really going to
take hold at the August meeting, about how far the balance sheet contraction
should really go," said Fed expert Lou Crandall, chief economist at
research service Wrightson ICAP.
"It's easy to get breathless about this and say the Fed's got a
crisis. On the other hand, this is revealing that there are fewer truly surplus
reserves in the system than we might have thought," he added.
The predicament indeed seems far from a crisis. But the upcoming
deliberations will give investors a window into how the Fed will unwind the
stimulus it injected to help pull the economy out of the financial crisis, and
ultimately how the market will react.
So far, the balance sheet reduction has proceeded with minimal market
disruptions, but much work remains ahead of the central bank.
Here's how it all works:
Since the financial crisis, the Fed had been a major player in the
Treasurys market, snapping up nearly $2 trillion worth during three rounds of
bond-buying that began in late 2008. Private demand has been left to pick up
the slack since the Fed ended quantitative easing in 2016.
In October, the Fed began allowing a set amount of proceeds from its bond holdings to run
off each month, while reinvesting the rest. Since that operation began, there
has been a $102 billion reduction in Treasury debt and mortgage-backed
securities on the balance sheet.
Concurrent with that has been a gain in interest rates, as the Fed also
has raised its funds level; meanwhile, some upward pressure has built on
government bond yields as the central bank has reduced its role in that part of
Federal Reserve Chairman Jerome Powell speaks at a news conference
following the Federal Open Market Committee meetings in Washington, March 21,
Most recently, the funds rate has risen to near the top of the 1.5
percent to 1.75 percent target range the FOMC set after March's hike.
Specifically, the benchmark is at 1.7 percent, just 0.05 points away from the
interest on excess reserves the Fed pays to banks that store cash at the
central bank. The interest rate on excess reserves (IOER), as it is known,
historically has served as a guide for the funds rate, and usually runs a bit
above the Fed's benchmark.
According to minutes from the May meeting, FOMC officials are concerned
that the funds rate is rising a bit more quickly than anticipated, causing a
tightening in money markets that would make a more aggressive unwind of the
balance sheet problematic.
A solution suggested at the meeting was that the Fed raise the rate paid
on reserves by 0.2 percent while it hikes the funds rate 0.25 percent. Doing so
would be expected to hold back the funds rate from getting too close to the
target ceiling, judging by the funds rate's tendency to trail behind the IOER
"We believe the Fed took this action since it has become
increasingly concerned with the tightening in money markets over recent months
and the pace by which its target fed funds effective rate is moving toward
IOER," Mark Cabana, rates strategist at Bank of America Merrill Lynch,
said in a recent note to clients.
"While much of the money market tightening is due to U.S. fiscal
policy (higher deficits and [Treasury] cash balance) we believe nascent signs
of reserve scarcity are contributing to the move," he added.
Cabana sees the balance sheet reduction concluding "toward the end
of 2019 or in early 2020 at the latest, with risks for an earlier-than-expected
end to the unwind depending on the Fed's choice of monetary policy
Part of the calculus will be predicated on the amount of excess reserves
Banks currently are holding nearly $1.9 trillion more than required at
the Fed, a number that has fallen by about $300 billion during the balance
sheet runoff. With regulations still demanding high cash levels for the
nation's biggest banks, Crandall estimated that level of reserves won't dip
much below $1.5 trillion.
That's a little more conservative than Cabana's projection that banks
won't want to see excess reserves, which peaked at $2.2 trillion, depleted by
more than $1 trillion total.
In balance sheet terms, Crandall's estimate implies a level of about
$3.7 trillion — or half a trillion below current levels, he said. By October,
the Fed will be allowing $50 billion a month to roll off, meaning that the
balance sheet reduction could be finished by later summer or early fall 2019.
Closing the roll-off program earlier than expected would be consistent
with a growing sense at the Fed that it is nearing the end of this rate-hiking
cycle. The policymaking FOMC has hiked the benchmark rate six times starting in
December 2015, and is indicating two more hikes this year and three the next.
However, with inflation remaining muted, some members believe the funds
rate won't need to go much farther.
The balance sheet rundown will be done "by the middle of next
year," Crandall said. "That's optimistic on my part, but I don't
think that's unrealistic."
Click here for the original article from CNBC.