May 16, 2022 | Vanguard Perspective

The Fed's plan to shrink its balance sheet, quickly

Josh Hirt, Senior Economist, Vanguard Investment Strategy Group

Josh Hirt, CFA
Senior Economist, Vanguard Investment Strategy Group

Brian Quigley, Vanguard head of MBS, agencies, and volatility

Brian Quigley
Vanguard head of MBS, agencies, and volatility

With inflation at a 40-year high and the labor market still tight, the Federal Reserve has pulled another instrument from its monetary policy toolbox. In addition to raising its key interest rate target by half a percentage point on May 4, the Fed has said it will start to shrink its balance sheet, another step in post-pandemic policy normalization.

Expanding the balance sheet by buying government bonds on the open market, known as quantitative easing, is an unconventional tool that the Fed and other central banks use to stimulate economies when policy interest rates are near or below zero and can't effectively be lowered further. Now, with rates rising, there's logic in the balance sheet's expansion being reversed.

"The Fed has minimal experience in removing stimulus by shrinking its balance sheet," said Josh Hirt, a Vanguard senior economist who studies the Fed, "so markets unsurprisingly take notice. That's especially true now as the Fed plans to move with a less cautious cadence compared with the previous time it employed quantitative tightening."

What's behind the faster pace of quantitative tightening?

The Fed plans to reduce its $8.5 trillion balance sheet beginning June 1, when it will no longer reinvest proceeds of up to $30 billion in maturing Treasury securities and up to $17.5 billion in maturing agency mortgage-backed securities per month. Beginning September 1, those caps will rise to $60 billion and $35 billion, respectively, for a maximum potential monthly balance sheet roll-off of $95 billion.

The Fed ended bond purchases only in March 2022, so this tightening is occurring considerably sooner than in the last reduction cycle. After the global financial crisis, the Fed ended quantitative easing purchases in 2014 but didn't start to reduce its balance sheet until 2017. The maximum roll-off then was roughly half of that expected this time around.

Three key factors explain today's faster pace:

  • The Fed's balance sheet is significantly larger this time relative to what would be considered an optimal range to effectively implement monetary policy.
  • The economy is at a more advanced stage of the business cycle and running hotter, as reflected in a smaller output gap, lower unemployment, and higher inflation than in 2014.
  • The Fed is likely less uncertain now about how markets and financial conditions may react given that it has at least some experience in communicating and executing roll-off plans.

The Fed's balance sheet roll-off: Different circumstances, different plan

Annotations on a line chart showing the Fed’s balance sheet indicate that its holdings expanded to $4.2 trillion, or 24% of nominal GDP, in November 2014. Annotations also indicate that the Fed’s holdings expanded to $8.5 trillion, or 35% of nominal GDP, in early 2022. Vanguard projections show the Fed reducing holdings over the coming years.
A shaded area shows Vanguard’s projection of the optimal balance sheet size rising from 2015 beyond 2027.
A table within the chart shows the inflation gap at negative 0.5%, the unemployment gap at 0.7%, and the output gap at negative 2.1% in November 2014. For May 2022, the table shows the inflation gap at 3.1%, the unemployment gap at negative 0.4%, and the output gap at negative 1.3%.

Notes: Inflation gap is defined as the core Personal Consumption Expenditures Index relative to the Federal Reserve's 2% inflation target. Employment gap is defined as the unemployment rate relative to NAIRU, the non-accelerating inflation rate of unemployment, the Fed's estimate of long-run unemployment. Output gap is defined as real GDP relative to the Congressional Budget Office's assessment of real potential GDP. Estimate for the balance sheet roll-off path assumes that monthly proceeds of $30 billion in Treasury securities and $17.5 billion in agency mortgage-backed securities (MBS) won't be reinvested in the three months beginning June 1, 2022. Beginning September 1, 2022, monthly Treasury and MBS roll-off caps will rise to $60 billion and $35 billion, respectively. For MBS, roll-off after September 1, 2022, assumes forecasted MBS prepayments per the Federal Reserve Bank of New York's "Federal Reserve Asset Purchases: The Pandemic Response and Considerations Ahead," March 2, 2022. Consistent with "Plans for Reducing the Size of the Federal Reserve's Balance Sheet," May 4, 2022, the estimated roll-off pace slows and then stops when the balance sheet is within range of optimal to allow assets to grow into the optimal range. The optimal balance sheet estimate comprises a constant $1.5 trillion level of required reserves, currency in circulation grown by 4% nominal GDP, and a constant 2.8% of GDP allocation for Treasury general account and other liabilities as per Fed Chairman Jerome Powell's March 8, 2019, speech "Monetary Policy: Normalization and the Road Ahead."

Sources: Federal Reserve Bank of St. Louis, Refinitiv, and Vanguard.

Why interest rates will remain the Fed's primary tool

What likely won't change is the Fed favoring the policy rate as its primary tool to effect policy, with balance sheet reduction running in the proverbial background to maximize predictability and minimize market disruption. That, along with concerns that balance sheet reduction would lead to much higher interest rates at the long end of the yield curve, is why the Fed set monthly caps for letting bonds mature passively rather than planning to actively sell securities from its portfolio.

Another consideration relates to the eventual terminal size of the balance sheet in terms of ensuring adequate market liquidity and carrying out monetary policy, which would serve as a guide for when the Fed would end asset roll-off. At present, this terminal size is uncertain. However, as shown in the graphic using simplifying assumptions, Vanguard estimates that the balance sheet may settle around 18% of GDP, or just above $5 trillion, before the Fed begins winding down and eventually ending its roll-off, at which point it will allow its assets to grow in relation to the size of the economy. "That level could be reached around the end of 2025, barring any pauses or significant deviations from the currently communicated plan," Hirt said.

A challenging environment for central banks ahead

The Fed's tightening plan comes with challenges, according to Brian Quigley, Vanguard head of MBS, agencies, and volatility. "Judging the appropriate pace and cumulative amount of tightening will be more difficult," Quigley said. "The Fed stepping away as a buyer of the market will prompt a period of adjustment that will ripple across financial markets as valuations will have to cheapen to attract more price-sensitive buyers. That this will be happening as a number of other major central banks will be hiking rates and unwinding their balance sheets is a complicating factor."

How effectively policymakers remove accommodations from global economies will remain a crucial theme for 2022 and beyond. In the near term, Vanguard economists continue to expect that economic growth and the labor market will moderate but remain strong toward year-end. Core measures of inflation (removing volatile food and energy prices) are similarly expected to moderate throughout the year but to stay at levels well above the Fed's 2% target.

Amid a challenging environment for central banks to balance inflation dynamics, the pace and eventual end point of policy rate increases will likely remain a focal point beyond 2022.