When will the Fed start shrinking its balance sheet? It's not about the bet: why the Fed's announcement is bad news for markets. Why is this necessary?

Over the past couple of months, the market has been actively discussing the Fed's plans to reduce its balance sheet. Let’s figure out how the regulator’s assets were “inflated” and why to get rid of them.

What is QE

Why is this necessary?

The theoretical effect of QE: the Central Bank buys the assets of banks, and they use the money received to expand lending at reduced rates. This leads to an increase in activity: people who previously did not have access to loans due to high rates begin to take out loans and pour them into the economy.

In the US, quantitative easing was introduced to achieve a number of goals. Among them:

Job creation. The Fed argued that the extra money from QE would allow business owners to hire more employees.
Lending incentives. By purchasing Treasury bonds, the Fed lowered long-term lending rates. This was necessary for economic growth.
Consumption growth. More money in the economy could stimulate consumption. This should have led to increased profitability of companies, growth of the stock market and, ultimately, economic recovery.
Support for low rates.In the late 2000s, the federal rate hovered between 0% and 0.25%. The Fed could not continue lowering rates - it needed another way to stimulate the economy.

How much has the Fed balance sheet reached?

In the United States, the quantitative easing policy was carried out in three stages: in 2008, 2010-2011 and 2012-2014.

Janet Yellen announced the end of the asset purchase program on October 29, 2014. At that time, the Fed's balance sheet reached $4.48 trillion. Due to reinvestment of bond payments, it has remained at approximately this level for almost two years.

The bulk of the balance sheet consists of Treasuries ($2.5 trillion) and mortgage-backed securities ($1.8 trillion), according to official filings.

Promises to reduce assets

Causes

Among the reasons for reducing the balance are the following:

A large stock of assets in the hands of the regulator creates a distorted picture of the market for investors. As a result, they take too many risks.
Buying a large number of mortgage bonds leads to excessive stimulation of the real estate market. At the same time, other sectors do not receive proper funding.
The size of the Fed's balance sheet is criticized by Republicans: according to them, it makes it possible to service a large budget deficit. Reducing assets may ease disagreements.

Volumes

In May, experts expressed expectations that in the first month of cuts, sales would affect mortgage and government bonds. Projections for the total amount varied, from $6 billion to $20 billion.

San Francisco Federal Reserve Bank President John Williams:

“We will begin the reduction carefully and gradually, each subsequent month reducing the volume of US government bonds on the Fed’s balance sheet and mortgage-backed securities by $6 billion and $4 billion, respectively. In the future, we will increase these figures by another $6 billion and "$4 billion, respectively, until the monthly reductions in Treasuries and mortgage-backed securities reach $30 billion and $20 billion, respectively. Thereafter, we will reduce the Fed's balance sheet in similar increments, and the amount of securities we hold will continue to decline in a gradual and predictable manner."

Deadlines

The Fed has been talking about its intentions to reduce its balance sheet for months now:

April - from the Fed minutes on March 14-15, it became known that the regulator will begin to refuse reinvestment in 2017:

“Meeting participants expect the committee to make a decision later this year on changes to the reinvestment policy.”

June - Fed Chair Janet Yellen stated that balance sheet contraction could begin “fairly soon” if economic growth meets the central bank’s expectations.
July 5 - minutes of the meeting June 13-14 that there are differences within the regulator regarding the timing of the new policy:

“Several Fed policymakers expect balance sheet contraction to begin “within two months,” although some would prefer to wait until the end of the year.”

July 11 - Federal Reserve Board Member Leil Brainard about readiness to begin reducing the balance:

"If the data continues to point to a strong labor market and strengthening economic activity, in my view it would be prudent to begin a gradual and predictable process of reducing the balance sheet soon."

July 26 - following the Fed meeting again that the reduction will begin “relatively soon” if economic dynamics coincide with expectations.
August 2 - San Francisco Fed President John Williams:

“It is planned to smoothly reduce the balance sheet by reducing the volume of reinvested proceeds from the redemption of other assets on the balance sheet. In my opinion, this process should begin this fall.”

Experts on the consequences

The reduction in the size of the US regulator's balance sheet is expected to have a serious impact on financial markets. However, it is difficult to predict exactly what it will be - this is the first experience of tapering QE for central banks. On this background New York Fed President William Dudley emphasized that reducing the balance will be a smooth and long process:

“We want this to be a background process. Therefore, we will do this very carefully and in close cooperation with the markets.”

Institute of International Finance: An estimated $200 billion cut in the Fed's balance sheet for emerging markets would be equivalent to three 0.25% interest rate hikes.
RBC Capital Markets trader Brad Scott believes the new policy will be a plus for some:

“The result will be an increase in bank profits. There will be more opportunities [for Wall Street] with increased volatility. New entrants are also likely to enter the market.”

Greg MyBride, Chief Financial Analyst at Bankrate.com, expects the process could take 15 or even 20 years, during which the Fed will take “breaks” from shrinking its balance sheet, or even return to expanding it, during crises:

"The Fed will not be able to sustain aggressive balance sheet contraction. The economy will inevitably experience a slowdown long before the balance sheet is significantly reduced."

#interestingIn its history, the Fed has already tried to reduce its balance sheet six times: in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000. On five occasions after this, the country's economy went into recession.

What matters is how exactly the Fed plans to reduce its balance sheet: not by selling securities, but by stopping reinvesting in them. From here DTI team presented the following picture of what will happen in the markets:

"Initial effect. Initially, the excess reserves of those from whom the Fed bought assets - primary dealers - will be reduced. These are large American banks - such as Goldman Sachs, JPMorgan - and their foreign competitors.
The main blow. Primary dealers, in turn, will reduce their purchases of securities of companies and smaller banks. For the latter, the blow will be much stronger: if large banks have excess reserves, then for small banks, selling their securities may become a matter of survival. Most likely, they will want to play it safe and issue issues before the QE phase-out begins. As a result, up to this point their stability may even increase briefly.
Financial markets. Even before the Fed stops buying assets, first of all, “junk” bonds will be thrown into the market. Next, the trend will spread to higher tranches of bonds, Treasuries and stocks.
Dollar. Usually, when banks have problems, the dollar strengthens - debt buyers need it. However, the sale of Treasuries will most likely cause distrust in this currency, against which it will begin to fall. Accordingly, inflation will increase.
Goods. Due to inflation and problems in the stock market, physical assets may attract the attention of investors: first of all, gold and oil. The latter, however, is unlikely to start growing - most likely, growth will simply stop.
Russia. The problems of the United States will naturally spread to the rest of the world, including Russia. Initially, the ruble will begin to fall. However, if banks begin to signal negative effects and the supply of money decreases, then the dynamics of the Russian currency will decrease in the opposite direction. In this case, the situation will depend on the actions of the Central Bank: whether the regulator will increase the money supply or allow the ruble to strengthen.
Further policy of the Fed. There is a relationship between a reduction in the balance sheet and an increase in the rate - both measures are elements of a contractionary policy. It is difficult to give quantitative estimates, since the connection between them is indirect. However, for now, statements by Fed representatives signal that the regulator is unlikely to abandon its plans to change the rate."

This week the US Federal Reserve and the Bank of Russia are likely to revise interest rates. The difference in profitability between ruble and dollar assets will become smaller. How will this affect investors?

Monetary policy in Russia and the United States is moving in opposite directions: while the Central Bank is gradually lowering the key rate, the Federal Reserve, on the contrary, is pushing it up. On March 21 and 23, first in the United States and then in Russia, regulators will announce their next decisions. Most likely, rates in both countries will be changed this week.

At its meeting on March 21, the Federal Open Market Committee will most likely increase the interest rate by 0.25 percentage points, to 1.75% per annum. This will be the most logical step based on the current dynamics of macroeconomic indicators. For investors, such a decision should not come as a surprise - much more important for them will be the rhetoric of the new Fed Chairman Jerome Powell, who will give a press conference following the meeting for the first time.

In turn, the board of directors of the Central Bank at a meeting on March 23 may reduce the key rate by 0.25 percentage points, to 7.25% per annum.

Macroeconomic arguments

At the end of January, a labor market report showed that the US economy was in excellent shape. The statistics were so convincing that investors saw it as a signal to accelerate the pace of the Fed's rate hike. Together with other concerns, this led to a significant decline in stock prices on the American market.

Even a month later, when it became clear that the economy was growing no faster than previously expected, volatility remained at high levels. Investors were not reassured by the fact that the adjusted inflation rate in February, which is what members of the Federal Reserve take into account, was 1.8%, and this is still below the target level of 2%.

They were also not convinced by Jerome Powell, who in his debut speech as head of the Fed noted that the sharp increase in wages at the beginning of the year was due to one-time bonuses after the adoption of tax reform, and real GDP growth of 2.5% speaks of confident, but still and slow economic development. At the same time, Powell emphasized that the decision to raise the rate for the fourth time this year depends on the dynamics of US GDP and the world economy and so far the plans remain unchanged.

The Bank of Russia, when determining the directions of monetary policy for the coming months, also takes into account inflation and inflation risks, and also takes into account the general state of the economy and the situation on the money market.

In addition, the situation on external and commodity markets is taken into account, since it affects inflation expectations and monetary conditions, sometimes no less than the actions of the Central Bank. Industrial production growth in Russia remains low. On March 19, data for February was published: in annual terms, the figure rose only by 1.5%.

It is worth noting that over the past 12 months, inflation has slowed down, and average rates on business loans have decreased by almost 3 percentage points. Low inflation is due to the relative stability of the ruble, which is ensured by a large positive trade balance of more than $10 billion per month, as well as freezing most monopoly tariffs. Thus, the easing of the Central Bank’s monetary policy in conditions of macroeconomic stability is bearing fruit, albeit rather slowly. This is a reason to continue reducing rates.

Implications for the US market

Despite a good start this year, investors have lost confidence in the rising market, and Powell's words do not inspire much optimism. Over the past four weeks, the S&P 500 has been experiencing significant declines on a regular basis. At the same time, the VIX volatility indicator exceeded 20 points, indicating the rising cost of downside insurance.

However, the current situation in the market is caused not only by expectations regarding the Fed's actions this year. The broad market index is also weighed down by a possible tightening of US trade policy towards China and shaky investor confidence in the largest social network Facebook.

Against this background, the Fed rate hike on March 21 will have a positive impact on the American stock market. The economic forecast, as well as Jerome Powell's speech, will also contribute to positive dynamics. The head of the Federal Reserve will certainly be able to convince investors that such dynamics in macroeconomic indicators will lead to three increases in the Fed’s key rate this year, and further increases will not occur until 2019.

Impact on the ruble

The narrowing of the gap between the Fed and Central Bank rates will affect the activity of carry trade operations with ruble assets - these transactions largely ensured the strengthening of the ruble in 2017.

Coupled with fluctuations in oil prices, this factor can have an impact on the ruble exchange rate. Nevertheless, a large influx of funds from exports will smooth out sharp movements in the foreign exchange market that may arise as a result of lower oil prices.

The dynamics of the ruble exchange rate will remain stable as long as the dollar exchange rate is trading below 66 rubles. But if this level is exceeded, the outflow of funds from carry traders from ruble instruments will increase.

In the absence of external shocks by the end of the year, the key rate of the Central Bank may be reduced to 6.75-7%. This will stimulate lower lending rates, which will create demand for goods and services, as well as housing construction.

Savings on deposits may increase slightly - by 3-4% by the end of the year, but lending activity will increase, retail trade turnover, sales of housing and durable goods will increase. The economy could grow by 1.8-2%. Thus, 2018 could be a relatively prosperous year for business and the population.

The US Federal Reserve is moving to a policy of “tightening” instead of “easing.” The Federal Reserve will begin to reduce assets on its balance sheet. The “operation” to normalize the bloated balance starts in October.

On some information sites and blogs you can find “sensational” reports about the impending collapse of the dollar and the imminent collapse of the “printing press” economy. The topic of the collapse of the United States worried Soviet minds, and worries Russian minds as well.

Today, other irrepressible authors write “” about the “withdrawal” of “dollars” from the US economy and the world economy, about the “massive purchase” of dollars by the Federal Reserve, and even about the “operation” to “liquidate” trillions of dollars. In a word, conspiracy theorists perked up.

What really happened?

Nothing yet, other than the announcement made by the US Federal Reserve. The American Federal Reserve will begin to reduce assets on its balance sheet. The “operation” to normalize the balance starts in October 2017 and will continue in 2018.

The decision on this was made at the last meeting of the Federal Open Market Committee (FOMC). In English, a message about the results of the meeting was published on the website of the Federal Reserve System (). The press release is absolutely open; no subscription or registration on the site is required. It can be read by a person with a high school knowledge of English.

The press release, dated September 20, contained positive information about the US labor market and economy. (For those waiting for the collapse of the dollar or the collapse of the American market system, it is, of course, negative.)

It is reported that the labor market in the United States continues to strengthen, along with moderate growth in economic activity, stability of household incomes, and continued low unemployment.

Household spending, the release notes, is growing at a moderate pace amid rising investment in fixed assets in recent quarters. Over the past 12 months, the country has experienced fairly low inflation: excluding food and energy prices, consumer price growth was just over 2 percent. Long-term inflation expectations have changed little.

In accordance with its charter, the FOMC is committed to ensuring maximum employment in the United States and price stability. Hurricanes Harvey, Irma and Maria devastated many areas across the country. Hurricane-related power outages and recovery efforts will certainly impact economic activity in the near term, but past experience suggests that they are unlikely to significantly change the direction of the national economy in the medium term. The committee continues to expect that with a gradual adjustment of monetary policy, U.S. economic activity "will develop at a moderate pace and labor market conditions will strengthen somewhat." Higher prices for gasoline and some other consumer goods following the hurricanes are likely to temporarily increase inflation. However, 12-month inflation is expected to remain even slightly below 2 percent in the near term and to “stabilize” around the 2 percent mark in the medium term.

Taking into account actual and expected labor market conditions and inflation, the committee is maintaining its target range for the federal funds rate of 1% to 1.25%. The current monetary policy is characterized as acceptable, which contributes to the further strengthening of the labor market and stabilization of the inflation rate.

The Committee expects that economic conditions in the country will evolve toward a gradual increase in the federal funds rate.

The press release concludes that the FOMC will begin the balance sheet normalization program in October described in the special June Supplement to the Policy Normalization Framework and Plans.

Recently, we remind analysts that the Fed will announce its entry into the market with a large number of securities. The Federal Reserve currently has assets on its balance sheet totaling 4.5 trillion. dollars.

The quantitative “tightening” that replaced the former “softening” does not at all mean the mythical “withdrawal” of dollars. No one is going to burn securities or throw tons of currency into the oven.

Firstly, the reduction of the balance sheet is not news and certainly not a sensation; it was announced back in June. Secondly, no one is going to cut “trillions” at once. The announced reduction is relatively small by the standards of American debt. At first, it is planned to “clear” the balance in the amount of $10 billion every month, then the amount will increase to $50 billion per month. Third, as kindly reminded, the Fed holds only 16% of US government bonds. And fourth, the Fed simply decided to reinvest proceeds from redeemed bonds into the purchase of new securities.

The volume of assets, we recall, inflated due to quantitative easing programs that were adopted to save the market in connection with the 2008 crisis and its consequences.

Experts do not predict any special effect from the “normalization” of the balance sheet of the American regulator.

Capital Economics, Kommersant notes, believe that the effect of “normalizing” the balance on the yield of government bonds will not be pronounced, since the Fed warned about its plans in advance. In addition, “quantitative tightening” of $10 billion per month is too small compared to the volume of the regulator’s assets.

And about the current consequences of the FOMC decision.

After the announcement of the decision, the US dollar exchange rate showed a noticeable increase, notes. The euro has fallen in price. In evening trading on the Moscow Exchange, the dollar rose against the ruble. WTI and Brent oil prices fell slightly.

In the future, the American stock market may lose a little, and after it the Russian stock market will lose. Moderate volatility is possible for the dollar/ruble pair, says Alor Broker analyst Sergei Korolev.

Against the backdrop of the announced unchanged Fed rate, the attractiveness of ruble assets remains, Art. is sure. analyst at Freedom Finance Investment Company Bogdan Zvarich. “There remains a fairly comfortable gap between the rates of the Federal Reserve and the Bank of Russia; accordingly, the attractiveness of carry trade operations remains. From this point of view, the unchanged Fed rate will be positive for our market - for the ruble and OFZ,” RBC quotes his opinion.

Thus, no financial turmoil is expected either in the United States or on the planet. The Fed is not going to “withdraw” trillions of dollars to nowhere: money does not tolerate a vacuum. Neither the dollar, nor the ruble, nor the euro are in danger of hyperinflation. The outlook for the US economy and open markets is generally positive. The United States will not collapse in the near or medium term.

The Fed's balance sheet contraction has begun! For the first time since September 2014, the volume of assets of the United States Federal Reserve fell below $4.44 trillion. Let us recall that the regulator began selling securities in the fourth quarter of 2017.

The balance will decrease gradually. It will be reduced by $6 billion in US debt securities and $4 billion in mortgage bonds per month. Every three months, this volume will increase by $6 and $4 billion, respectively, until the monthly amount reaches $30 and $20 billion, that is, “cruising speed” will be reached a year after the start.

Fed balance sheet and forecast for its reduction from J.P. Morgan

Source: A.M. J.P. Morgan

According to this plan, by the end of December 2021, the Fed's balance sheet will have to drop to $2.2 trillion. In J.P. Morgan is doubtful about this, according to their estimates, assets will decrease to $2.9 trillion. The Fed's portfolio will remain in US government bonds worth $1.6 trillion (now there are 2.5 trillion) and mortgage securities worth 1 trillion (now there are 1.8 trillion).

Summary from Investbrothers

In our opinion, it will be quite difficult for the Federal Reserve to implement its plan 100%. Most likely, in a few years some kind of unforeseen circumstances may arise and the regulator will have to reconsider the speed of getting rid of debt securities. It is possible that due to the risks of the global economy, the Fed will eventually turn on the printing press again.

Other statistics:

Might be interesting:

In April 2017, Fed officials announced plans to significantly reduce the size of the Fed's balance sheet as early as 2017. The need for this decision was motivated as follows. The Fed's balance sheet contains securities purchased by the Fed during QE. These are mainly treasury bonds and MBS (mortgage backed securities). These securities were purchased in order to lower rates. The goal was achieved, the US economy came out of recession and now there is no point in keeping them on the balance sheet.
Also, Fed officials said that the sale of MBS and UST would lead to an increase in rates in the economy, i.e. will become another tool for tightening monetary policy, similar to raising the discount rate.
But this week the blog Econimica offered another explanation for the need to shrink the Fed's balance sheet.
See diagram. The yellow curve is the Fed's balance sheet, the blue curve is the banks' excess reserves.

As you can see, during QE, the Fed's balance sheet grew from $0.9 trillion to $4.5 trillion, and banks' excess reserves grew from $0 to $2.7 trillion. dollars. In other words, the Fed issued 3.6 trillion. dollars, but 2.7 trillion. dollars remained on the correspondent. bank accounts at the Federal Reserve. According to the mind, these are 2.7 trillion. dollars should have entered the economy in the form of loans to the company. banks were not included in non-financial organizations because there was not enough investment. projects (assets with an acceptable return to risk ratio). The question arises: why was it necessary to print 3.6 trillion. dollars if 2.7 trillion. dollars (75%) never entered the economy. Apparently, the size of the issue was dictated by the number of defaulted MBS on the balance sheets of banks. To improve the banks' balance sheets, these mortgage-backed securities had to be purchased from the banks at non-market prices. This is how the banking system was saved from bankruptcy.

Since 2008, the Fed has been paying banks a return on excess reserves at the IOER (interest on excess reserves) rate. The Fed sets the IOER rate in the same way as the discount rate. Now its level is 1.25%.
Now look, in 2015, excess reserves began to slowly decline. By the end of 2016, they fell by 0.8 trillion. dollars up to 1.9 trillion. dollars. Apparently, this was due to the improvement in the economy. And then the Fed began to vigorously raise the discount rate and excess reserves began to grow again. See diagram.

The beige curve is the Fed policy rate, but IOER is equal to the Fed policy rate. The diagram shows that excess reserves began to grow simultaneously with the rise in the Fed rate and, accordingly, the IOER rate. And they grew from a minimum of 200 billion dollars.
As a result, paying banks for their excess reserves has become costly for the Fed.

The black curve is the Fed's expenses in the form of payments to banks for their excess reserves. Now it is 27 billion dollars a year. There will be more to come.

At a Fed discount rate of 3%, Fed spending would be $64 billion in annual terms. It's a lot. And there is no point in paying banks such large sums. Banks are already doing well. Therefore, excess reserves need to be reduced. To achieve this, the Fed's balance sheet will be reduced.
True, it will not be possible to significantly reduce the balance. Those MBS that the Fed once bought from banks are now worth 10% of the purchase price.