The Federal Open Market Committee (FOMC) met last week and announced a path to lighten their balance sheet. Why is this important and what are the risks?
Why unload the balance sheet?
The FRB has approximately $4.5T on their balance sheet. By buying US treasuries, they infuse cash into the system. As the economy strengthens, they have the ability to remove that cash from the system by letting those bonds mature and collecting the cash proceeds. This should elicit a similar response to a rate hike, but markets were fairly tame in response (likely because the FOMC has been telegraphing this move for several months now).
A large reason to unload the balance sheet is also to make room for the ability to increase accommodative policy in the future. Should we experience another recession while interest rates remain low, the FRB will need every tool at its disposal to attempt to infuse capital.
What could go wrong?
The muted response from markets could mean that they are selling short the impact this program will have. Beginning in October, the FOMC is going to allow $10B to mature without re-investment, increasing that figure by $10B/quarter until it reaches a cap of $50B… That’s $200B per year once the cap is reached. This could cause a shock wave to interest rates that are unnatural given the lack of GDP needed to support a higher rate environment.
It is understandable that the FOMC wants to reduce the balance sheet and increase interest rates. They need to do this to effectively restock their ammunition for the next recession. It is worth noting, however, that moving too quickly can actually be the catalyst to said recession.
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