The Federal Reserve may begin later this year to shrink a balance sheet that swelled to $4.5 trillion after the financial crisis, using a system of gradually increasing caps to salve concerns about how much liquidity would be pulled from markets each month.
"The caps would initially be set at low levels and then be raised every months, over a set period of time," according to minutes of the central bank's monetary policy committee meeting in early May. The Fed began buying Treasury bonds and mortgage-backed securities by the billions per month to stimulate economic growth after the 2008 crisis froze credit and sent unemployment soaring; its total assets rapidly quadrupled.
Nearly all Fed policymakers "expressed a favorable view of this general approach," according to the minutes, which were published on Wednesday. "Limiting the magnitude of the monthly reductions in the Federal Reserve's securities holdings on an ongoing basis could help mitigate the risk of adverse effects on market functioning or outsized effects on interest rates."
The goal of shrinking the balance sheet is to reduce the Fed's deep involvement in global financial markets while curbing incentives for corporations to load up on cheap debt. Reversing so-called quantitative easing would also soak up excess liquidity from the banking system, helping the Fed to skirt criticism over its payment of above-market interest rates on foreign lenders' deposits.
The minutes didn't disclose what levels the caps might be set at, or how much they might increase. The French bank BNP Paribas (BNPQY) predicted earlier this year that the Fed, which maintained the liquidity achieved through its purchases by reinvesting money from maturing securities, might pare its balance sheet by as much as $20 billion a month starting in the middle of next year.
Whether the Fed starts the process then, or later this year, members were unanimous in their reluctance to take any such step before establishing that slowing economic growth earlier this was, indeed, transitory as they believed. That also influenced their decision to leave short-term rates unchanged at a range of 0.75% to 1%.
Outside economists nonetheless predict the central bank will raise rates at least twice more before Dec. 31, and interest-rate futures indicate the next move may be in mid-June. The minutes did little to counter that possibility, noting that "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."
"If the economy performs as we project, the funds rate will continue to move higher next year, and this is in addition to an expected tapering of balance sheet reinvestments," he said in a note to clients on Wednesday.
While increasing rates benefits banks such as Citigroup (C) - Get Report and JPMorgan Chase (JPM) - Get Report that pass hikes on to borrowers more quickly than depositors, there are also risks. Higher interest raises costs for borrowers with adjustable-rate loans such as mortgages and heightens the potential that corporate borrowers with low credit ratings may default, compounding the risk from any slowdown in growth.
"The pathway to higher rates and a smaller balance sheet is first and foremost predicated on continued evidence that weakness in the first quarter was temporary," Lindsey Piegza, the chief economist at Stifel, said in an e-mail.
Lackluster consumer spending and uncertainty about whether and when the government stimulus proposed by President Donald Trump might be enacted "may undermine at least some committee members' confidence in a more robust state of affairs from April to June," she said.
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