The minutes of the Federal Reserve’s (Fed) May 2–3, 2017 meeting signaled that the Fed is likely to continue tightening monetary policy and may begin to normalize (reduce) its balance sheet toward year-end. The unwinding of the balance sheet by the Fed and the strategy it employs to accomplish this will be material to global markets. Despite signaling that it will clearly articulate its exit strategy so as to not be disruptive, the Fed is walking a difficult tightrope while trying to weigh its goals against the objectives of the European Central Bank (ECB) and Bank of Japan (BOJ).
THE FED’S BALANCE SHEET
The Fed implemented the first round of its bond-buying program, known as quantitative easing (QE), in 2008 to inject capital into the market, hoping to stimulate economic growth while keeping interest rates low. Several iterations of QE later, the Fed had purchased more than $4 trillion of bonds, including $2.5
trillion in Treasuries and $1.8 trillion in mortgage-backed securities. Even though the latest QE program in the U.S. ended more than two years ago (October 2014), the Fed has rolled proceeds from maturing bonds into new purchases, keeping the size of its balance sheet relatively constant and also likely keeping interest rates slightly lower than they otherwise would be. To date, according to Bloomberg data,
the Fed’s balance sheet totals approximately 24% of U.S. gross domestic product (GDP). Although it is too early to judge the success or failure of QE, it is irrefutable that it did calm the markets after the 2007–08 financial crisis. Stocks saw strong performance as the balance sheet grew, but have also
performed well since QE ended. Stock market performance may have been helped by QE, as low bond market yields pushed more investors toward stocks, but recent performance may be more attributable to the impact of earnings growth, a fundamental driver of stock prices. Nonetheless, with stocks at all time highs, the Fed is likely to act cautiously, as it does not want to disrupt markets. The Fed’s strategy to reduce the balance sheet begins with communicating policy changes in a clear and timely fashion. The terms “gradual” and “predictable” were used in the FOMC’s May minutes, and because of this advanced signaling, we think the short term risk to markets may be limited.
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