By C.Jay Engel
The minutes from the March FOMC meeting were released yesterday, and we discover that the balance sheet theme is really coming together. The massive portfolio held by the Fed is allegedly going to be reversed over the coming years. The way to initiate this shrinkage in the balance sheet is to first stop reinvesting the return that it is making on all the bonds it holds. From the minutes, we learn that the Fed is considering two options for how to do this:
An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee's policy intentions while only modestly slowing reductions in the Committee's securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.
Option 1: "Gradual" phasing out of the level of reinvestment. Option 2: Immediate halting of any reinvestment whatsoever.
These are going to be the debated options moving forward in the coming FOMC meetings and Fed members' speeches. The Fed tends to prefer "gradual" approaches to things, keeping at the forefront of its mind the possible reactions (temper tantrums) by stock and bond market participants. If the Fed decides to begin phasing out reinvestment, it will be much later this year. This gives it two quarters in the meantime to conduct two more rate hikes.
The FOMC minutes give the suggestion that, as the Fed tries to get back to "normal" interest rates and balance sheet levels, it will be going back and forth between the two methods: Fed Funds rate hikes and slowing reinvestment. While watching paint dry has been more exciting than the rate hike progress, it seems it is going to be another two years before the Fed gets the Fed Funds rate into the 2% range (if the Fed can make it that far) if it alternates between a reinvestment policy change and a Fed Funds hike.
Of course, all this could come unraveled by a single poor employment report. The wizards determining the direction of our economy are actually as blind as anyone else. They are walking on eggshells, unsure of what to do and where to go next. How does one reverse an 8-year 400% increase in the central bank's balance sheet without causing a commotion? That would be impossible.
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