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.
Here's how it all works:
Since the financial crisis, the Fed had been a major player in the Treasurys market, snapping up nearly $2 trillion worth during three rounds of bond-buying that began in late 2008. Private demand has been left to pick up the slack since the Fed ended quantitative easing in 2016.
In October, the Fed began allowing a set amount of proceeds from its bond holdings to run off each month, while reinvesting the rest. Since that operation began, there has been a $102 billion reduction in Treasury debt and mortgage-backed securities on the balance sheet.
Concurrent with that has been a gain in interest rates, as the Fed also has raised its funds level; meanwhile, some upward pressure has built on government bond yields as the central bank has reduced its role in that part of the market.
Most recently, the funds rate has risen to near the top of the 1.5 percent to 1.75 percent target range the FOMC set after March's hike. Specifically, the benchmark is at 1.7 percent, just 0.05 points away from the interest on excess reserves the Fed pays to banks that store cash at the central bank. The interest rate on excess reserves (IOER), as it is known, historically has served as a guide for the funds rate, and usually runs a bit above the Fed's benchmark.
According to minutes from the May meeting, FOMC officials are concerned that the funds rate is rising a bit more quickly than anticipated, causing a tightening in money markets that would make a more aggressive unwind of the balance sheet problematic.
A solution suggested at the meeting was that the Fed raise the rate paid on reserves by 0.2 percent while it hikes the funds rate 0.25 percent. Doing so would be expected to hold back the funds rate from getting too close to the target ceiling, judging by the funds rate's tendency to trail behind the IOER rate.
"We believe the Fed took this action since it has become increasingly concerned with the tightening in money markets over recent months and the pace by which its target fed funds effective rate is moving toward IOER," Mark Cabana, rates strategist at Bank of America Merrill Lynch, said in a recent note to clients.
"While much of the money market tightening is due to U.S. fiscal policy (higher deficits and [Treasury] cash balance) we believe nascent signs of reserve scarcity are contributing to the move," he added.
Cabana sees the balance sheet reduction concluding "toward the end of 2019 or in early 2020 at the latest, with risks for an earlier-than-expected end to the unwind depending on the Fed's choice of monetary policy framework."
Part of the calculus will be predicated on the amount of excess reserves running off.
Banks currently are holding nearly $1.9 trillion more than required at the Fed, a number that has fallen by about $300 billion during the balance sheet runoff. With regulations still demanding high cash levels for the nation's biggest banks, Crandall estimated that level of reserves won't dip much below $1.5 trillion.
That's a little more conservative than Cabana's projection that banks won't want to see excess reserves, which peaked at $2.2 trillion, depleted by more than $1 trillion total.
In balance sheet terms, Crandall's estimate implies a level of about $3.7 trillion — or half a trillion below current levels, he said. By October, the Fed will be allowing $50 billion a month to roll off, meaning that the balance sheet reduction could be finished by later summer or early fall 2019.
Closing the roll-off program earlier than expected would be consistent with a growing sense at the Fed that it is nearing the end of this rate-hiking cycle. The policymaking FOMC has hiked the benchmark rate six times starting in December 2015, and is indicating two more hikes this year and three the next.
However, with inflation remaining muted, some members believe the funds rate won't need to go much farther.
The balance sheet rundown will be done "by the middle of next year," Crandall said. "That's optimistic on my part, but I don't think that's unrealistic."