Will The Fed Start Reducing Its Balance Sheet? Here Is Goldman's Answer

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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

  • Recent public comments from Fed officials have renewed interest in the outlook for the central bank’s balance sheet. Here we tackle the most common questions from investors.
  • At the moment, the Fed fully reinvests principal payments into Treasuries and agency MBS, and we still expect this to continue until the middle of 2018. The committee could decide to end full reinvestment sooner due to (1) unexpectedly strong growth, (2) concern about excessive dollar appreciation, and/or (3) a desire to ensure a smooth transition to the next Fed Chair. However, we would expect the FOMC to proceed cautiously after 2013’s “taper tantrum”, and it may need to consider how its actions intersect with debt management and regulatory goals.
  • We would be very surprised to see a discussion of asset sales under Chair Yellen’s leadership, but 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.
  • 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.
  • For broader financial conditions, the impact will likely depend on how the committee communicates the end to reinvestments. One of the important lessons from the Fed’s experience with QE has been that signaling channels appear most important. The same probably goes for winding down the balance sheet: the market implications will likely depend on what these steps tell us about policymakers’ broader intentions.

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.


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