Fed balance sheet reduction strategy

Monetary tightening, which includes different dynamics from the 2014 – 2017 model tapering period, must also include further shrinkage in terms of proactive inflation management.

Strategic rapid balance sheet reduction… Monetary tightening, which includes different dynamics from the 2014 – 2017 model tapering period, must also include further shrinkage in terms of proactive inflation management. Because, since the March 2020 period, there is a dimension to be worried about the fact that the excess liquidity, which has been printed to break the effects of Covid, will also create inflation. Therefore, it is necessary to understand that the Fed will not wait for 3 years in the QT phase this time after ending QE and moving to rate hikes.


Bonds that will be eliminated by redemption… In a normal balance sheet reduction, the Fed does not replace the bonds that have been redeemed and these papers are deducted from the balance sheet. Now, since the balance sheet has not grown naturally (almost twice the size of 2014), we will assume that contraction will not occur naturally either. In other words, the area covered by the balance sheet on GDP should be narrowed. As the GDP will grow at a more normal rate, we will not have a problem on that side. When we look at the Treasury and MBS redemptions from the balance sheet details of the Fed, we see a situation like the one in the table.


Maturity Breakdown of Securities, Loans and Other Selected Assets and Liabilities, January 12, 2022… Source: Federal Reserve, FRED


The Treasury's short-term redemption bonds cover an area of ​​approximately $1.1 trillion (77 billion in 15 days, 329.7 billion in 3 months, 728 billion in 1 year). When the Fed does not replace these bonds (it buys bonds from the market and makes repos and deposits), it will have drawn this much liquidity. Treasury bonds, which will be redeemed in 1 to 5 years, cover an area of ​​​​2.2 trillion dollars. This means that the Fed's balance sheet will decrease by $3.3 trillion in 5 years from Treasury bonds alone. It is clear that 'MBS's need to be 'thrown' down here, because the housing market is also on the rise, and indeed, inflating demand and rising prices, mortgage rates are also a problem.


Liquidity and interest rate risks… While the Fed waits for the redemption of short-term bonds, it will narrow the balance sheet faster by selling bonds on the long-term side. Such a move will bring more stability in short-term interest rates and higher movement in long-term interest rates. It is understandable that it affects the long-term side with balance sheet management in terms of yield curve control. As the Fed cuts bonds, balance sheet reserves and overnight repo/reverse repo transactions will be critical. In order to prevent monetary policy failure, it is necessary to avoid the mismatch of the liquidity and collateral situation in the market. In this context, the Fed carries out daily overnight repo operations against Treasury securities, agency debt securities and agency mortgage-backed securities under the SRF. On the other hand, as part of the FIMA repo facility, the Federal Reserve makes overnight repurchase agreements with foreign government agencies against Treasury securities held at the Federal Reserve Bank of New York, as needed. In order to support the effective implementation of monetary policy and the smooth functioning of the market, functionality is required in the money markets for repo facilities to function as a support.


Conclusion? While the Central Bank uses monetary policy tools to control short-term interest rates, it will affect long-term bond rates and housing rates with sales within the scope of balance sheet reduction. The effect of the Fed balance sheet flow on Treasury yields is highly uncertain, which should also be considered in conjunction with the projected Fed funding rate. The most likely outcome is to increase the upward pressure on long-term Treasury yields, which supports our expectation of a move towards the theoretical 2.50% band.

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