By Michael S. Derby
(Reuters) – The Federal Reserve announced plans on Wednesday to slow the pace of its balance sheet reduction after warning against the shift for much of the start of the year.
The Fed said that starting June 1, it is reducing the cap on Treasury bonds that mature and cannot be replaced to $25 billion from the current cap of up to $60 billion per month. The Fed left the cap on how much mortgage-backed securities it can remove from its books at $35 billion per month and will reinvest any excess MBS principal payments in Treasury bonds.
The move was announced at the end of the Federal Reserve’s two-day Federal Open Market Committee meeting, during which the US central bank left interest rates unchanged.
The slowdown in the pace of the runoff election had been widely expected, although market participants were unsure whether the tapering of the runoff election would be announced at this week’s FOMC meeting or at the meeting scheduled for June. To the extent that there was a surprise, many analysts had their eyes on a reduction in the Treasury’s outflow cap to $30 billion per month.
The new Treasury outflow cap “is a little more aggressive than we expected, but as expected the repayment cap has been maintained.” [mortgage bonds] unchanged at $35 billion per month – although in the current higher interest rate environment few of the underlying mortgages are coming due,” said Paul Ashworth, chief North America economist at Capital Economics.
Fed officials have argued that by moderating the pace of drawdowns, they will reduce the risk of unwanted market disruptions like those that occurred during the last balance sheet contraction. They have also indicated that by slowing the pace of balance sheet reduction they may be able to reduce the overall size of their holdings more.
US Federal Reserve Chairman Jerome Powell reiterated these views in his press conference, saying that reducing the pace of unwinding will allow the central bank to “more gradually” achieve the ultimate goal of its balance sheet.
After doubling the size of its balance sheet from before the pandemic to about $9 trillion, the Fed phased out some of its holdings of Treasury and mortgage-backed bonds. This process, which began in the second half of 2022, has resulted in the Fed’s balance sheet shrinking to $7.5 trillion.
Balance sheet reduction, also known as quantitative tightening or QT, occurs independently of changes in central banks’ interest rate policy. However, rate hikes and QT were both part of the process of scaling back stimulus provided by the Fed due to the economic impact of the coronavirus pandemic. QT aims to reduce excessive liquidity in the financial system to a level that continues to allow normal money market volatility and allows the Fed to control the federal funds rate.
While the decline has not had a major impact on the market so far, the latest shift could only have a marginal impact. The QT cut “has the fortuitous effect of putting some downward pressure on yields and reducing the risk of a rise toward 5%,” analysts at Evercore ISI said.
The Fed has not yet set a target for what its balance sheet should look like after the QT ends. A New York Fed report last month said market demand for liquidity will be the main driver of the QT endgame, with the runoff expected to end sometime in 2025 and the Fed’s holdings potentially between 6 trillion and 6.5 trillion US dollars lie.
(Reporting by Michael S. Derby; Editing by Andrea Ricci)