Most Federal Reserve officials agree that they will begin shrinking their super-sized balance sheet later this year. What they don't want to discuss in detail yet is how that will shape their plans to continue raising the short-term interest rate in 2018.
The minutes of the March meeting employed some key words to outline plans to trim the balance sheet, which ballooned to $4.5 trillion following three rounds of bond purchases. Reductions need to be "gradual and predictable," and should be accomplished by "phasing out" of reinvestments, meaning the central bank wouldn't abruptly stop repurchasing all debt instruments when they mature. Finally, policy makers indicated reductions would start "later this year," although they didn't provide details on amounts.
The critical line the Fed is trying to walk is one of slow balance-sheet shrinkage that doesn't tighten financial conditions so much that it becomes a second tool of monetary policy. Most Fed officials want the federal funds rate to be the primary instrument, according to the minutes published on Wednesday. That may be little more than wishful thinking.
"I am highly skeptical" the balance-sheet strategy won't impact monetary policy, said Laura Rosner, senior U.S. economist at BNP Paribas in New York. "It is hard to imagine that this isn't going to lead to significant tightening."
Ripple effect
U.S. central bankers penciled in three rate hikes into their 2018 forecast, according to the median estimate. That may incorporate some balance-sheet runoff, though it may also reflect a lot of optimism about the limited effects that will have on longer-term Treasury rates, credit spreads and mortgages — a mix of longer-term borrowing costs that economists generally describe as financial conditions. The Fed said it would run off both Treasuries and mortgage-backed securities.
New York Fed President William Dudley, who is also vice chairman of the Federal Open Market Committee, said he is aware that a change in policy on the balance sheet will ripple through credit and foreign exchange markets.
"If we start to normalize the balance sheet, that's a substitute for short-term rate hikes," and "we might actually decide at the same time to take a little pause in terms of raising short-term interest rates," he said in a Bloomberg Television interview last week. He added that he isn't worried about a "violent" market reaction to balance-sheet reductions "because it is already factored in."
Hard to predict
Communication matters a lot when it comes to limiting the impact of Fed policy on borrowing costs. Officials have telegraphed their latest rate hikes so well that financial conditions eased after their increases in December and March.
The Fed's balance sheet is so huge, however, that the impact is difficult to predict. The Fed's portfolio includes $426 billion of Treasury securities set to mature in 2018, and $352 billion more that will mature in 2019. Not all of that will have to be financed by private investors in a single year because the Fed wants gradual runoff.
In a section of the minutes where central bankers discussed their forecasts for monetary policy and the economy, participants signaled their plans to raise interest rates in 2017 would coincide with shrinkage of the balance sheet that could start "before the end of the year." That may imply that the central bank's median estimate of three rate hikes for 2018 includes the effects of slightly tighter credit conditions.
Winter Lull
"For the first time, they're acknowledging" that their interest-rate outlook "incorporates balance-sheet assumptions," said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, N.J.
Investors are paying a lot of attention to Dudley's comments that the rate path could suffer interruptions or changes. Crandall said that, even with three hikes this year and next, there could be a lull in the winter.
But following the release of the minutes, investors reduced the expected amount of Fed tightening in 2018 via short-term interest rates to just 1.5 hikes, the least since Nov. 11. The FOMC schedules eight meetings a year with the next set for May 2-3 in Washington.
The matter on how the balance sheet could affect the funds rate path won't be settled until investors know the amount the Fed plans to run off.
