July FOMC minutes detail balance sheet normalization
The Fed’s balance sheet has bloated to over $4 trillion from ~$900 billion before the crisis. The Fed’s monetary easing involved three rounds of quantitative easing (or QE). QE involved periodically purchasing Treasury and agency-backed securities.
As part of normalization, the Fed planned to scale-down its balance sheet. Specifically:
- The size of the Fed’s balance sheet would be reduced “gradually and predictably.”
- In the long run, the size of the balance sheet will be reduced to the smallest level “consistent with efficient implementation of monetary policy.”
- After normalization, Federal Open Market Committee (or FOMC) members generally agreed that assets should consist primarily of Treasury securities.
- FOMC participants were still divided on whether to stop reinvesting in maturing Treasuries before or after the lift-off in the federal funds rate.
- FOMC participants were also divided on whether to offload its mortgage-backed securities’ (or MBS) portfolio or retain some portion of it. Some participants favored offloading in order to loosen the Fed’s hold on mortgage rates—relative to other interest rates. Some participants preferred to keep the option to sell the MBS at a later date.
Impact of balance sheet normalization on financial markets and bond prices
If the Fed reduced its Treasury and MBS holdings, a considerable amount of liquidity would be erased from the market. Interest rates would likely trend higher.
The Fed’s monthly purchases of Treasuries and agency-backed debt, and reinvestment of proceeds from maturing securities, also create considerable demand. After the Fed stopped these purchases, the securities’ price would likely trend lower and yields would trend higher.
This would affect exchange-traded funds (or ETFs) investing in Treasuries like the iShares 20+ Year Treasury Bond ETF (TLT) and the Vanguard Total Bond Market ETF (BND). Lower Treasury prices would benefit inverse ETFs like the ProShares UltraShort 20+ Year Treasury (TBT).
Offloading MBS would also affect the housing market. The Fed’s MBS portfolio creates an artificial cap on mortgage rates. Offloading would lead to higher mortgage rates. This would affect ETFs like the iShares U.S. Real Estate ETF (IYR) and the State Street SPDR Homebuilders ETF (XHB).
Using these tools to normalize policy would only occur if the Fed closes in on price stability and inflation. The next part of the series will discuss the Fed’s view on employment and inflation.