The Fed’s Balance Sheet Strategy Is A Big Deal

The Federal Reserve’s balance sheet strategy will start off slowly at a decline of around $10 billion a month increasing in 3 month intervals until it reaches a max decline of $50 billion a month or around $600 billion yearly decline approximately 1.25 years after the start date. QE2 also consisted of $600 billion over 8 months of purchases compared to $600 billion a year with the balance sheet contraction plan. I calculated using the end of reinvestment of both treasuries and mortgage securities. I think this is very comparable to reversing QE and will push the 10 year yield and real rates higher.

On average the Fed balance sheet expanded by around 700 billion a year between pre-QE and 2015. So if we’re looking at a reduction of 600 billion a year, I would say that’s significant, considering the effectiveness of QE in pushing yields and real rates lower.

The Fed is, in essence, going to be draining loanable funds from the banking system through not buying bonds and ceasing to continue to inject money into the banking system. When a bond matures, the Fed has since the Financial Crisis rolled over the principal payment into new bonds leaving reserves liquidity in the banking system unchanged. Now they will be ending the reinvestment of maturing securities which will cause banking system liquidity to tighten. This decreased supply of credit in the banking system pushes up the price of it also known as the interest rate. When the Fed raises the Federal Funds Rate it sets a floor under interbank rates where one bank wouldn’t loan to the other for less than it can be parked at the Fed. This is because the Fed now pays interest on excess reserves. Reversing QE although in a slightly less but similar magnitude can be expected to put upward pressure on yields and real inflation-adjusted interest rates in my view.

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