Fed sets process to wind down $4.5 trillion balance sheet

KEY POINTS

• Federal Reserve officials appear to be in synch on how they plan to unravel the mammoth stimulus implemented during the financial crisis.
• The central bank is holding a $4.5 trillion portfolio, known as its "balance sheet," of mostly government debt it accumulated in the years after the crisis.

Federal Reserve officials appear to be in sync on how they plan to unravel the mammoth stimulus implemented during the financial crisis.

The Fed is holding a $4.5 trillion portfolio, known as its "balance sheet," of mostly government debt it accumulated in the years after the crisis. Until now, the central bank has been taking the proceeds it receives from maturing debt and reinvesting them in more bonds.

In recent days, officials have been indicating that the balance sheet will be unwound, likely starting later in the year, raising questions from investors about how the process will work and what impact it will have.

According to minutes released Wednesday from the Federal Open Market Committee meeting earlier this month, the central bank sees a system where it will announce cap limits on how much it will allow to roll off each month without reinvesting. Any amount it receives in repayments that exceeds the cap limit will be reinvested.

The process is similar to the tapering it did of the monthly bond-buying program known as quantitative easing. In that case, the Fed announced a gradual reduction in the amount of bonds it would be buying each month. In this case, it will be announcing the level of those bonds it will allow to roll off.

Caps will be set at low levels initially then gradually raised every three months, according to the meeting summary. The cap level would reach a limit that would be designed to take the balance sheet down to a certain level — perhaps around $2.5 trillion, according to some reports.

"Nearly all policymakers expressed a favorable view of this general approach," the minutes stated.

The Fed has used its balance sheet to keep interest rates low and the economy moving higher since the crisis. By buying up bonds, the Fed provided demand that held government yields back. In keeping the balance sheet large, it helped prevent a flood of bonds into the market that might have driven yields higher and pushed up borrowing costs. In addition, stocks surged after the crisis almost in lockstep with the Fed's balance sheet growth.

The schedule will be pre-announced, a measure that FOMC members agreed "was consistent with the Committee's intention to reduce the (balance sheet) in a gradual and predictable manner."

Fed watchers have worried that the process, if not done correctly, could be disruptive and drive up rates unexpectedly.

Central bank officials indeed have equated the roll-off process with rate increases, but believe that the plan set forth this month "could help mitigate the risk of adverse effects on market functioning or outsized effects on interest rates," the minutes said. "The approach would also likely be fairly straightforward to communicate."

Once set in motion, the process will not be altered unless there is a "material deterioration" in economic conditions, the document added.

The process comes as the Fed is on a gradual path toward normalizing interest rates. The central bank set its benchmark target to near zero during the crisis but has enacted three rate hikes since then, the most recent being in March.

Though the committee chose not to hike this month, it indicated strongly that another increase is coming in June, a move already priced into financial markets.

Fed officials at this month's meeting discussed the first-quarter slowness that saw GDP grow less than 1 percent, but they saw the contributing factors, including a slowdown in inflation, as "transitory" and thus unlikely to slow progress through the year.

In fact, members said the risks to their economic forecasts are tilted higher.

"Most participants judged that if economic information came in about in line with their expectations, it would soon be appropriate for the committee to take another step in removing some policy accommodation," the minutes said in a statement that is Fed vernacular for a rate hike ahead.

"The unwind in the Federal Reserve's balance sheet holds Chair Yellen's signature gradual approach," said Quincy Krosby, chief market strategist at Prudential Financial, in an email. "She will not allow a quick unwind, nor anything that surprises markets."

Watch: Fed set to trim balance sheet this year