Normalizing the Fed’s Balance Sheet – Not so Fast by Steve Malin of Allianz Global Investors

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In its efforts to revive the economy in the wake of the financial crisis, the Federal Reserve took extraordinary measures that included a dramatic increase in its holdings of Treasury and mortgage-backed securities (MBS). But while the building of a massive portfolio helped make ultra-low interest rates possible, it also created or exacerbated economic and financial market distortions, which the Fed is now seeking to normalize.

While the Fed began tightening interest rates back in December 2015, a plan to unwind its Treasury and MBS holdings was just announced on June 16, 2017. As the process proceeds, the Fed plans to continue implementing monetary policy by adjusting both the federal funds rate and the rate of interest on excess reserves. Balance sheet normalization will not serve as a monetary policy tool in the absence of economic and financial market stresses.

The Fed intends to shrink its securities holdings to no more than it will need to implement monetary policy efficiently and meet collateral requirements for outstanding currency. Accordingly, perhaps as much as $2 trillion of maturing US Treasury and will roll off the Fed’s balance sheet without being replaced.

Still, the Fed does not expect the process to cause interest rates to rise by more than roughly 25-50 basis points over the next several years. With aggregate demand for Treasuries and MBS falling as the Fed ceases to reinvest principal, the timing, scale and composition of new security issuance will play a more important role in setting securities’ prices and yields.

For more on how the Fed plans to unwind its US Treasury and MBS holdings, as well as the impact on investors, please see the latest edition of Under the Macroscope by Steve Malin.

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