- The Fed has tried to reduce its balance sheet six times in the past, with five ending in recession, MKM Partners data show.
- The balance sheet stands at $4.5 trillion and is composed mostly of Treasurys and mortgage-backed securities.
- The Fed is expected to announce the beginning of a program to cut the size in September.
The Federal Reserve's looming attempt to shrink its mammoth portfolio of bonds comes with an ugly track record: Virtually every time the central bank has tried it in the past, recessions have followed.
Over the past several months, the Fed has prepared markets for the upcoming effort to reduce the $4.5 trillion it currently holds of mostly Treasurys and mortgage-backed securities. The balance sheet ballooned as the Fed sought to stimulate the economy out of its financial crisis morass.
The Fed has embarked on six such reduction efforts in the past — in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000.
Of those episodes, five ended in recession, according to research from Michael Darda, chief economist and market strategist at MKM Partners. The balance sheet trend mirrors what has happened much of the time when the Fed has tried to raise rates over a prolonged period of time, with 10 of the last 13 tightening cycles ending in recession.
"Moreover, outside of the 1920s and 1930s, there is no precedent for double-digit annual declines in the balance sheet/base that will likely begin to occur late next year," Darda said in a note.
Indeed, the Fed's efforts have been unprecedented.
Three rounds of purchases through a program known as quantitative easing or, more colloquially, "money printing," brought the balance sheet to his level. Recently revealed plans show how the Fed will scale back.
Since it began the balance sheet expansion, the Fed has reinvested the proceeds it gets from bonds each month to keep the size stable. In a program that is expected to be announced in September, the Fed will begin letting a specified size roll off each month and reinvest the rest. The roll-off target will be small and increase quarterly until it reaches $50 billion a month.
Current market expectations are that the Fed will keep rolling off proceeds until the balance sheet hits around $2 trillion to $2.5 trillion, a process that could take four or five years. Fed Chair Janet Yellen likes to say the process will be akin to "watching paint dry" and won't be disruptive to markets.
However, skeptics question whether it will be so painless.
"Against this historical portrait, a pressing question arises: will credit markets and equity volatility remain quiescent moving into the second half of next year when balance sheet reduction and rate hikes — a double-barreled tightening — begin to move along at full force?" Darda said.
He believes that if the Fed follows a slow trajectory that is mindful of low inflation trends "then we think there will be nothing to worry about." However, he cautions that the Fed may not have as much room to tighten policy as it thinks.
Markets generally seem to agree with Darda.
While Fed officials have indicated that one more rate hike this year is likely, traders give it just a 45.5 percent chance, according to the CME. Fed funds futures contracts imply a rate by the end of 2018 at 1.45 percent, which point to barely two rate increases between now and the end of next year.
By contrast, Fed projections released in June pointed to four moves during the same period.
Various economists, including a group calling itself Fed Up, are urging policymakers to increase their current inflation target from 2 percent and hold off on further rate hikes.