How Will the Fed Reduce Its Balance Sheet?

David J. Stockton discusses the implications and risks in the US Federal Reserve reducing its $4.5 trillion balance sheet.
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Eitan Urkowitz: This is Eitan Urkowitz at the Peterson Institute for International Economics. Recently, the FOMC [Federal Open Market Committee] announced that they're going to be reducing the Fed's bank balance sheet. Joining me is Dave Stockton, senior fellow at the Institute and former chief economist at the Federal Reserve. Thanks for joining me, Dave.

David Stockton: Pleasure.

Eitan Urkowitz: So what is the Fed's bank balance sheet and what does it actually consist of?

David Stockton: So the Fed's balance sheet consists on the liability side of currency, the currency that people hold and the public holds not just the US citizens but foreign citizens as well, and bank reserves, the funds that the banks park with the Fed. And on the asset side, the Fed owns treasury securities and mortgage-backed securities. So it's a pretty big portfolio, about $4.5 trillion dollars currently.

Eitan Urkowitz: So Dave, why has it grown so big? What is this $4.5 trillion number?

David Stockton: The Fed's balance sheet of $4.5 trillion is historically large. I mean, before the financial crisis, the Fed's balance sheet was a little under $1 trillion. So it's grown enormously. And the reason why it's grown is that during the financial crisis the Fed lowered interest rates to zero and was still looking for opportunities to provide more accommodation, more stimulus to the overall economy.

And one of the ways that the Fed decided to do that was by purchasing lots of long-term assets and bringing those on to their balance sheet with the idea of driving up the price of those assets and driving down the interest rate on those assets in order to provide stimulus. And so that was, in essence, the QEs [quantitative easings] that have gotten talked about so much: QE1, 2, and 3. And in doing so, obviously, it left the Fed now with a very large outsized balance sheet.

Eitan Urkowitz: Why is the Fed looking to reduce the balance sheet now?

David Stockton: The Fed actually hasn't stated that it's going to reduce it now. It stated that it's going to likely start thinking about reducing it later this year or early next year. The reason is that the economy has improved to the point where the Fed is actually now raising interest rates. And the Fed feels it has a little more room to begin to trim back its overall portfolio of Treasury securities and mortgage-backed securities and to do so in a way that wouldn't necessarily need them to reverse policy quickly in the future in terms of needing to bring those assets back onto the balance sheet if things [were] weakening. They could just cut interest rates and they've got a little bit of room to do so now. And they haven't had that for quite some time.

Eitan Urkowitz: Are there any risks involved in reducing the balance sheet, or is it going to be smooth playing from here on out?

David Stockton: Well, that remains to be seen. And obviously, the Fed is working hard currently to try to put in place policies that minimize the risks associated with shrinking its balance sheet. One of the things that they don't want to do is to reduce the balance sheet in a way that creates any unnecessary financial market volatility.

Think back to the taper tantrum in 2013 when Ben Bernanke just talked about trimming back the amount of assets they were purchasing. And it led to a big spike in long-term interest rates. The Fed doesn't want that to happen again. So it's trying to, by getting out in front of this indicating that its intentions are to begin to reduce the balance sheet is to minimize the risks associated with any sort of financial market disruption.

And I think what they want to do is put in place a policy that pretty much puts the reduction in the Fed's balance sheet on autopilot. So it isn't a discretionary meeting-by-meeting decision. But they'll announce ahead of time their intention to begin to shrink and shrink by a certain amount over a certain time period. They haven't worked out all the details yet, but I think that's what they're shooting for. And the risk would be obviously if they mismanaged that you could get more financial market volatility and undo some of, I think, the Fed still sees the economy as needing some stimulus. And they don't want to undo that and certainly undo it quickly.

Eitan Urkowitz: Thank you, Dave.