In its most recent policy meeting in March, the US Federal Reserve hinted at plans to shrink its balance sheet at a rapid pace of $95 billion per month, its latest attempt to tame red-hot inflation in addition to its aggressive rate hikes in the coming months.
Fed officials “generally agreed” to slash up to $60 billion of its Treasury securities and about $35 billion of its mortgage-backed securities per month.
But what exactly does the Fed mean with the planned balance sheet reduction?
The Fed’s balance sheet, as with businesses, is a list of its assets and liabilities. The liabilities include US currency in circulation and the reserves deposited by commercial banks, while assets are Treasury securities like notes and bonds, and mortgage-backed securities (MBS).
During economic crises like the COVID-19 pandemic, the Fed buys more assets in a policy called quantitative easing. Quantitative easing (QE), also known as asset purchases, are among the tools that the Fed uses aside from interest rate cuts to push inflation to a targeted range.
In March 2020, to help boost money supply and ease the impact of the pandemic on the US financial system and the economy, the Fed went on a large-scale asset purchasing program, buying trillions of dollars in Treasury bonds and MBS.
At the time that the Fed embarked on its QE in 2020, the central bank’s balance sheet only stood at $4.31 trillion. The figure has now ballooned to an unprecedented level of $8.97 trillion as of last week, accounting for about a third of the US national debt.
Conversely, the Fed employs quantitative tightening (QT), or tapering, to normalise its balance sheet by reducing the pace of its asset purchases or outright selling them on the open market. It is one of the tools that the Fed uses aside from interest rates to influence inflation and money supply in the economy.
A move to reduce the Fed’s balance sheet focuses on the assets the Fed holds. Quantitative tightening reduces money supply in the economy as the Fed stops replacing securities once they mature. At a pace of $95 billion per month, the Fed’s asset reduction will shrink the money supply at a pace greater than its attempts in the past.
The last time the Fed attempted to reduce its balance sheet was between 2017 and 2019 when the Fed managed to shrink its balance sheet to $3.8 trillion ($50 billion per month) but was forced to buy back assets again six months later when the pandemic hammered the US economy.
Members of the Federal Open Market Committee expect to begin the QT process again “possibly as early as at the Committee’s May meeting,” according to the minutes of the Fed’s March meeting released in early April.
What the QT means for the stock market
During central banks’ QE processes, interest rates are pushed lower and there is more liquidity in the banking system, encouraging investors to spend more on risky assets and consumers to spend more. In contrast, some analysts expect the Fed’s asset tapering to have a reverse effect on stock markets.
The Fed’s hawkish move may “be a headwind in the face of stocks in particular,” Robert Phipps, a director at Per Stirling Capital Management, said in a recent note.
However, UBS said in an earlier report that the overall direct impact of a QT program “is likely to be limited.”
“Investors should not view it as a structural drag on asset returns,” UBS said, adding that asset tapering is also unlikely to have a big impact on liquidity or inflation.
Impact on USD
QT is seen as a positive sign for the US dollar as the move prices in higher rates when the Fed tightens. Further, as the Fed stops replacing maturing securities, money supply will shrink, possibly pushing the USD higher, if all else stays the same.