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How the Fed will answer its $4.5 trillion question


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How the Fed will answer its $4.5 trillion question

Market participants know with some confidence that the U.S. Federal Reserve will begin trimming its $4.5 trillion in assets this year, and they know how the central bank intends to accomplish that task, but no one — perhaps not even policymakers at the Fed — know how big the balance sheet will be when the process is finished.

In June, the Fed released a detailed plan explaining that it will cut the balance sheet by capping its reinvestment in U.S. Treasurys and mortgage-backed securities. It remains unclear, however, where the central bank will stop. The estimates fall in a wide range, anywhere from $1 trillion to $4 trillion.

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San Francisco Fed President John Williams says returning the central bank's balance sheet to an ideal size could take four years. Source: Associated Press

The central bank used quantitative easing to pump money into banks by purchasing government bonds from them. In an attempt to return to normal policy settings, the Fed will allow some of its bonds to mature without buying new ones to replace them. The extent to which it allows bank reserves to fall could provide some insight as to how much slack it thinks it needs should the economy slow and unconventional tools become necessary.

Balance sheet mechanics

It will not be possible for the Federal Reserve to shrink its balance sheet to precrisis levels, analysts say. The amount of cash in the economy, which counts as a liability, has grown, and the bank has to hold assets, like bonds, against it. Returning to a precrisis-size balance sheet would also require a significant overhaul of the bank's operating framework, which would play a sizable role in determining the size of the Federal Reserve's balance sheet, said Ken Matheny, senior economist at Macroeconomic Advisers.

"The Fed would like to preserve the capacity to use unconventional tools in the future in the event of a big negative shock, and that would include in that purchases of long-term assets like it engaged in during and after the last crisis," Matheny said in an interview. "It seems likely that in order to preserve that option, the Fed's not going to go back to the old operating framework," of few excess reserves.

Paring down its balance sheet that drastically would require the central bank to "change its operating framework a couple of times, and it probably doesn't want to do that," he added.

Matheny in an email said that before the financial crisis, the Federal Reserve adjusted reserves through relatively small-scale open market operations to influence the price of reserves. Now, it relies on arbitrage type of forces to influence the federal funds rate as it sets the interest rate on excess reserves and the interest rate on overnight reverse repos.

The size of the balance sheet will likely be shaped by the size of the economy and the desire to allow the central bank to keep some of the policy tools it gained by growing its balance sheet, said Paul Mortimer-Lee, chief market economist and head of U.S. economics at BNP Paribas.

Mortimer-Lee said it is unlikely that the size of the balance sheet will provide insight into the Fed's view of the health of the economy. The central bank has stressed the importance of unwinding its balance sheet without any economic repercussions. Unless there is a downturn as the balance sheet unwinds, it will remain unrelated to overall economic conditions, he added.

"All these guys are going to take this incredibly cautiously because we don't know," Mortimer-Lee said in an interview while discussing both the Federal Reserve and the European Central Bank. "We haven't been there before."

Range of possibilities

It is unknown how large the balance sheet will be, Matheny said, because the central bank either does not know or will not publicly announce it. "We can say, I think, two things, and they're not very precise: one is the balance sheet will be smaller than it is today, and secondly, it will be larger than it was in 2007."

At an event in Las Vegas earlier this month, San Francisco Fed President John Williams called the balance sheet reduction "the worst-kept secret in the world" while projecting the return to an ideal size for the balance sheet would take about four years. Analysts say that ideal size will depend on what is happening in the economy.

Federal Reserve Governor Jerome Powell told CNBC in June that, "it's hard for me to see the balance sheet getting lower than $2.5 trillion, $2.5 [trilion] to $3 trillion." Maintaining a balance sheet that size would be driven by currency circulation and the requirements for banks to hold highly liquid assets, said Scott Colbert, chief economist at Commerce Bank.

"The balance sheet simply supports currency in circulation," Colbert explained, adding that currency in circulation grows 4% or 5% each year, yielding an estimate of $1 trillion or $1.5 trillion in growth over 10 years. "That's the minimum balance that they could target if they reversed quantitative easing entirely."

Mandates requiring large banks to hold liquid assets also help determine how large a balance sheet the central bank must maintain, Colbert said.

"The banks that are larger than $250 billion in size, and that counts for about 85 percent to 90 percent of all the assets in the system, are mandated to hold enough liquid assets on their balance sheet to cover what they think would be a stressed outflow of deposits and loans over a 30-day period of time," he said. "There's the thought that they're likely to still want to have some extra reserves for these banks that have to maintain highly liquid assets, and the banks themselves would want to have some reserves at the bank because of these requirements. So that's why the guestimate seems to be something bigger than $1.5 trillion but less than $2.5 trillion."

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Fed Governor Jerome Powell has estimated that the balance sheet will be greater than $2.5 trillion.

Source: Associated Press

"I think they want to maintain a little bit of flexibility there if they need to use the balance sheet in the future for whatever reason," James Marple said of the Fed, adding that they could use the balance sheet in response to a particular financial event or to counteract economic overheating. "They'd like it to be at a more normal level, but will still have some potential role to play in their policy." According to data from the Federal Reserve, the central bank's balance sheet was $869 billion on Aug. 8, 2007.
The economy has grown since the recession, so that helps explain why the balance sheet will not return to precrisis size, said James Marple, senior economist at TD Bank Group. The central bank also is not eager to return to relying on market scarcity to control short-term interest rates or give up the tools the larger balance sheet has afforded them to guide monetary policy, he added.

No magic number

When it comes to the Fed defending the size of a healthy balance sheet, it is unclear if the central bank has any plans for justification, said Bricklin Dwyer, senior North America economist at BNP Paribas.

"It's pretty arbitrary whether or not $2.5 trillion or $3 trillion on your balance sheet, whether or not that's appropriate," he said when asked about potential rationale coming from the central bank.

Dwyer added that, based on previous comments from Janet Yellen, the Fed will assess what is appropriate for balance sheet reduction at particular points in time, taking into account whether they think assets are being inflated or distorted.

"I don't think there's any magical 2.5 trillion or 3 trillion number," he stated. "Under positive circumstances, you need four good years of growth ahead of us with nothing bad happening for them to get to that point, so I think they'll assess that."