US Federal Reserve will continue to reduce its balance sheet until 2020

After raising its interest rate by 20 basis points Wednesday (13 June), it is unlikely that the US Federal Reserve will adjust plans for reducing its balance sheet until late 2019 or 2020, according to one economist.

In a note to clients, Andreas Johnson, economist at Nordic Bank at SEB, said the process of reducing the Fed’s balance sheet has got increased attention and criticism lately.

For example, Reserve Bank of India governor Urjit Patel recently criticised the Fed’s reduction of the balance sheet arguing that the unwinding contributes to turmoil in emerging markets. The argument is that the US tax cuts cause the budget deficit to widen, resulting in higher than projected issuance of debt.

This means that the reduction of the balance sheet coincides with an increase in issuance of US Treasuries causing a shortage of dollar liquidity. This could be one explanation for the effective funds rate having moved toward the top of its range and resulted in the adjustment Wednesday (13 June) where the Fed hiked the interest rate on excessive reserves (IOER) by 20 basis points rather than the normal 25 bps.

Patel argues that the Fed must adjust the plan to reduce the balance sheet in order to take into account the unexpected rise in government debt issuance.

But Johnson notes: “The question is whether the Fed will listen to the criticism. This seems very unlikely in the near-term. Firstly, it cannot be determined with certainty what has caused the effective Fed funds rate to move above the target mid-point.

“Secondly, Chairman Jerome Powell argued on Wednesday that the adjustment to the IOER could be done again if necessary. Thirdly, the ambition is that the reduction of the balance sheet should be gradual and predictable; only a major disturbance in financial markets or the economy would cause the Fed to adjust the plan for its balance sheet. Fourthly, a near-term policy change from the Fed would cause a major disruption of markets.

 “The Fed has indicated that the long-term size of its balance sheet should be in the range of $2.4 to 3.5trn. Reinvestments of maturing securities are being reduced gradually according to predetermined maximum amounts (thresholds). The current threshold is $30bn and is set to rise to the maximum of $50bn by October. The current size of the balance sheet is about $4.3trn.”

If the Fed sticks to the plan, the balance sheet will be close to the suggested $3.5trn upper range in late 2019, Johnson concluded.

“Our take is that unless there is a severe market disruption, the Fed will continue to reduce the size of the balance sheet as planned, meaning the process will be completed by the end of 2019 or more likely during 2020.”