With the fate of Fed's balance sheet suddenly under Wall Street's spotlight, following last week's hints by several Fed presidents that a runoff in the balance sheet may be on the horizon and prompting various sellside analysts to
share their thoughts. Overnight, Goldman too decided to opine on the
rising debate of what happens next to the Fed's $4.2 trillion balance
sheet, and cutting to the case, says that it continues to expect full
reinvestments to end in the middle of 2018 (i.e., no runoff for at least
18 months), but adds that while "we would be very surprised to see a
discussion of asset sales under Chair Yellen’s leadership" a shift to
"more active management of the maturity of new Treasury purchases could
be an option; shortening the duration of new purchases would quicken
portfolio runoff once it begins."
Goldman also confirms what other analysts have said previously,
namely that "ending reinvestments would result in an increase in MBS
issuance to private investors. For Treasuries, the impact on duration
supply will depend on how the incoming administration chooses to adjust
its sources of financing."
However, should inflation indeed spike up and surprise to the upside
as Jeff Gundlach recently hinted, the Fed may have no choice but to
engage in just this kind of balance sheet deleveraging, which many have
said should have taken place prior to the Fed's launch of rite hikes in
December of 2015.
For more details on Goldman's opinion, read the full Goldman Q&A on the Fed’s Balance Sheet
Q: What is the current status of the balance sheet, and what has the FOMC said about its outlook?
A: The Federal Reserve currently reinvests all principal
payments from its Treasury, agency debt, and agency MBS portfolios,
thereby holding the nominal size of its securities portfolio unchanged.
The Federal Reserve Bank of New York conducts agency MBS purchases in
the open market on behalf of the FOMC. For maturing Treasury securities,
the Fed rolls over all proceeds into newly-issued Treasuries at auction
(Exhibit 1). These purchases do not compete with other investors: the
Federal Reserve submits noncompetitive bids, and the Treasury increases
the size of its auctions to match the amount of the Fed’s request. At
the moment, the Fed does not actively manage the duration of its
purchases: it simply allocates its bids proportionally to Treasury’s
public offering amounts.
Exhibit 1: Fed Replacing Maturing Treasuries at Auction
In its December 2015 statement, the FOMC indicated that full
reinvestment of the securities portfolio would continue until
“normalization of the level of the federal funds rate is well under
way”. In comments shortly after that meeting, New York Fed President
Dudley indicated that the reinvestment decision would hinge mostly on
the backdrop for growth: “Now the words ‘well underway’ in the FOMC
statement are vague … If the economy were growing very quickly
and the risks of an early return to the zero lower bound for the federal
funds rate were deemed to be low, then I could see ending reinvestment
at a relatively low federal funds rate. In contrast, if the economy
lacked forward momentum and the risks of a return to the zero lower
bound were judged to be considerably higher, I would want to continue
reinvestment until the federal funds rate was higher.”
Market participants have interpreted “well under way” to mean
3-4 additional funds rate increases from current levels. In its regular
surveys the New York Fed asks for the expected level of the funds rate
“when the Committee first changes its reinvestment policy”. The
median response from primary dealer economists in the December survey
was 1.38%, and the median response from the separate investor survey was
1.56%. In both cases respondents thought reinvestment policy would
change about 18 months from December, or around the middle of 2018.
Q: What has changed more recently?
A: Fed officials have begun discussing the balance sheet more often in their public remarks.
Exhibit 2 summarizes their comments so far, including the brief mention
of the balance sheet in the December FOMC meeting minutes. None of
these comments on its own would be particularly noteworthy. For example,
Boston President Rosengren has been discussing options for the balance
sheet for some time, and the remarks in the minutes and from Governor
Brainard simply restate the committee’s existing guidance—that the time
for ending full reinvestments could change as the outlook evolves. However,
taken together, recent remarks suggest that officials may be starting
to fine-tune their views now that the committee has gotten a couple rate
hikes under its belt. They may also be getting ahead
of potential criticism from the incoming administration, as some of the
economic advisers to President-elect Trump appear to favor a smaller Fed
balance sheet with a shorter duration.