Fed’s balance sheet normalization – what to expect

Financial markets, especially bonds, emerging market equities and currencies, were severely shocked back in May-September 2013 when Ben Bernanke, then Fed chairman, announced the intention to slow down the Fed’s purchases of securities.

Jun 14, 2017 | John Greenwood

The key lesson of that “taper tantrum” episode is that the Fed’s balance sheet reduction or normalization program must be pre-announced and conducted in a manner that does not disrupt financial markets.

Ever since the Federal Open Market Committee (FOMC) started discussing “policy normalization” in 2014, the authorities have had in mind two sets of measures: (1) raising the federal funds rate back up to “normal” levels, and (2) returning the balance sheet to a “normal” size.

On June 14, the FOMC updated its key principles for balance sheet normalization. One principle was that rate normalization should be “well under way” before the balance sheet could be reduced in size. Given FOMC members have a longer term target for the federal funds rate of 3.0%, and that on June 14 the target range was raised to 1.00%-1.25%, one more hike this year would put the top end of the target range at 1.5%, half way to the median long run projection. That would allow for a start on balance sheet normalization later this year. A second principle calls for a “gradual and predictable” run-off (allowing maturing securities to simply roll off the Fed’s balance sheet) rather than outright sales.

The shape and timing of the taper 

In two statements on June 14, the FOMC proposed that the taper would start later this year. The amount of run-offs would start small, and gradually be raised at quarterly intervals.

When the Fed starts normalizing its balance sheet, they must keep in mind two sets of objectives: (1) on the asset side the end-game is to end up with all investments in US Treasuries and (2) on the liabilities side the aim will be to end up with a balance sheet that accommodates the growing quantity of Federal Reserve Notes and the desired level of commercial bank reserves.

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