Federal Reserve Chairman Jerome Powell caused a bit of a stir during a chat with the Economics Club of Washington Thursday by saying the central bank's balance sheet would be "substantially" smaller when it finishes normalizing its size.
That comes as no surprise to Fed watchers, since the central bank is in the middle of reducing its assets by as much as $50 billion a month as its securities holdings mature. The more interesting aspect of the Fed's balance-sheet plans was revealed in the minutes of last month's meeting of the Federal Open Market Committee, which were released Wednesday.
To review, the Fed's balance sheet was expanded from under $1 trillion before the financial crisis in 2008 to over $4.4 trillion by October 2017. Since then, the Fed has been paring its assets, which mainly consist of U.S. Treasury and agency mortgage-backed securities, to just over $4 trillion as of Jan. 3.
That, however, understates the liquidity drain from the financial system thanks to the Fed's open-market operations. Its main liability-U.S. currency in circulation-has increased by almost $140 billion in that span, leaving fewer reserves available for the banking system. That point was made quite clearly by Powell in his question-and-answer session.
What a "substantially" smaller Fed balance sheet means was left unanswered in the Q&A conducted by the Carlyle Group's David Rubenstein. A further reduction to $3.5 trillion, as envisioned by many Fed watchers, would seem quite substantial when viewed in the context of ever-increasing demand for currency in circulation, especially outside the U.S. where greenbacks remain a highly favored store of value and medium of exchange.
The latest FOMC minutes shed light on the committee's thinking on the composition of its assets, which should be of more relevance to financial markets. In particular, the Fed would prefer to return its portfolio to plain-vanilla Treasuries and get away from its Ginnie Mae, Fannie Mae and Freddie Mac MBS.
What stood out to J.P. Morgan economists in the minutes was that some FOMC participants considered cutting MBS holdings more quickly by selling them outright, rather than just passively letting principal get paid down. The former would mark a reversal of the Fed's current policy, which the bank anticipated would leave $1 trillion of MBS on the central bank's balance sheet when it was normalized by 2021.
The housing market already has felt the impact of policy shifts even beyond the Fed's interest-rate increases and the significant reduction of tax benefits of homeownership in the tax-cut legislation that took effect last year. An accelerated reduction in Fed holdings of MBS would likely further push up mortgage interest rates at a time housing activity is faltering.
The Fed sees its balance-sheet policies as being separate from its monetary policy, which it says is effected through interest-rate changes. But both the amount and makeup of the Fed's assets also affect on the financial markets and the economy.
Last Friday, however, Powell indicated the pace of the balance-sheet shrinkage might be adjusted as circumstances dictated, which was a less-recognized factor in the stock market's strong rally since then. Powell also indicated the Fed would be "patient" in raising short-term interest rates, a point he reiterated Thursday, which has also helped power the rebound in risk assets.
In the past week, the Fed has moved away from the previous notion that its balance sheet normalization was on autopilot. The size and composition of central-bank balance sheets have been powerful determinants of financial-market and economic growth since the financial crisis. Perhaps policy makers will begin to recognize this.
Corrections and amplifications:
Some Fed analysts predict the Fed will reduce its balance sheet to $3.5 trillion. An earlier version of this article mistakenly gave the amount as $3.5 billion.
Write to Randall W. Forsyth at firstname.lastname@example.org