The Federal Reserve could have a surprise in store for investors this week, even if everyone already knows the central bank is raising interest rates.
Along with the quarter-point increase in the Fed's benchmark short-term target, the policymaking Federal Open Market Committee is likely to announce another change that would signal an early exit from its history-making program to reduce the level of bonds being held on its balance sheet.
The mechanics are a little complicated. Yet it suggests that what once appeared to be an operation to shrink the amount of bonds the Fed owns that would have run well into the next decade could be wrapped up next year, or early 2020 at the latest.
Instead of reducing the balance sheet from its peak of $4.5 trillion to $2.5 trillion or so as some Fed officials indicated, the impact could be far less — perhaps, some suggest, to $3.5 trillion or even a little more.
It all depends on how tight financial markets get. Tightening in the money markets, and an unexpected push of the fed funds rate toward the high end of its target range, would be key factors in prompting the Fed to re-examine its policy normalization efforts from financial crisis extremes.
If the balance sheet runoff ends sooner then anticipated, investors probably can expect that the rate-hiking cycle could wrap up a bit earlier as well.
"There is a very active debate, and it's probably really going to take hold at the August meeting, about how far the balance sheet contraction should really go," said Fed expert Lou Crandall, chief economist at research service Wrightson ICAP.
"It's easy to get breathless about this and say the Fed's got a crisis. On the other hand, this is revealing that there are fewer truly surplus reserves in the system than we might have thought," he added.
The predicament indeed seems far from a crisis. But the upcoming deliberations will give investors a window into how the Fed will unwind the stimulus it injected to help pull the economy out of the financial crisis, and ultimately how the market will react.
So far, the balance sheet reduction has proceeded with minimal market disruptions, but much work remains ahead of the central bank.