Fed’s March Meeting Minutes Point to Gradual Balance-Sheet Reduction
April 06, 2017
Minutes from the Federal Reserve Open Market Committee (FOMC) March meeting highlight key aspects of the committee’s thinking, including the committee’s intent to reduce its balance sheet gradually over time.
From a big-picture perspective, the FOMC anticipates reducing the reinvestment of its Treasury and mortgage-backed securities holdings later this year in a gradual, predictable way rather than all at once. That timing is consistent with our view, but the market had been split between expecting an early 2018 start and a late 2017 start, so some investors may be surprised.
Other notable content from the minutes:
The timing isn’t predetermined, but “most participants” in the meeting expect to start reducing the Fed’s balance sheet later this year. This is consistent with our view that the fourth quarter is the likely starting point for reducing reinvestment, and it makes sense to us. The committee wants to start reducing reinvestment before the transition to a new Fed chair takes place, which is likely to be in early 2018.
The committee expects to phase out asset purchases rather than stop altogether. It’s not a surprise, but some committee members favor a rapid halt to asset purchases, arguing that this approach would be easier to communicate. Still, that point of view doesn’t appear to be winning the day—most of the committee expects a gradual slowdown rather than a sudden stop.
Balance-sheet reduction should be passive and predictable. The idea is to have the reduction in the Fed’s balance sheet be as much of a nonevent for the market as possible. The committee wants the reduction to be on autopilot unless or until the economic outlook changes, an approach that would be less likely to disrupt markets. It can also be viewed as either easing the transition for a new Fed chair next year or tying the new chair’s hands—depending on your perspective.
The committee wants interest rates—not the balance sheet—to be the primary policy tool. This notion goes hand in glove with being passive and predictable. Putting the tapering of reinvestments on autopilot should quickly make this tool less relevant in policy, allowing the committee to use interest rates to tighten or ease policy instead of tweaking asset purchases. This desire is a big reason why the committee wants to wait until rate hikes are “well under way” before reducing the balance sheet: it needs enough space to either hike or cut rates in order for rates to be the primary policy tool.
The Fed seems surprisingly open to quantifying a specific level for interest rates once it starts reducing its balance sheet. The committee has generally preferred flexibility rather than rules-based policymaking, but the meeting minutes note that “several” participants want to set a specific level for the fed funds rate ahead of time; “some others” don’t. This discussion could still be under way, but we should expect members of the committee to be asked what threshold they envision. The answer is likely to be “50 basis points higher than where we are now,” since that’s when they seem inclined to start the balance-sheet reduction, but we’ll see what they say.
The committee generally prefers to phase out reinvestments in both Treasury securities and mortgages—but it’s not unanimous. There’s been a lot of debate among economists about whether the committee would prefer to reduce only mortgages first; we still think it’ll reduce both types of securities simultaneously. The minutes don’t quite settle that debate—the discussion isn’t entirely clear about whether it will be simultaneous or sequenced. However, we think a simultaneous reduction is closer to the text of the minutes as written.
The committee plans to communicate its plans iteratively. As the committee moves closer to a decision, we’ll get more information. The Fed doesn’t want this process to be disruptive, so it will provide as much information as possible as soon as possible. And the Fed knows it needs to convey its expectations for the eventual size of the balance sheet. We expect the balance sheet will still be significantly larger than it was precrisis, but no more than about half of the current $4 trillion amount.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.