Call it QT: quantitative tightening.
It's the reverse of quantitative easing, or QE, the unconventional policy used by the Federal Reserve to restore the U.S. economy to health following the financial crisis of 2007 and 2008. That strategy involved buying Treasury bonds and mortgage-backed securities by the billions per month to stimulate growth; the Fed's total assets rapidly quadrupled to about $4.5 trillion.
Ever since, questions have hounded Fed officials, led by Chair Janet Yellen, over when -- and whether -- the central bank's balance sheet would start to shrink back toward its former level below $1 trillion. According to economists at the French bank BNP Paribas (BNPQY) , the answer could come later this year, and there's a risk that markets would react quickly -- and dramatically.
The Fed is likely to announce a plan, before the end of 2017, to reduce assets by about $20 billion a month starting in mid-2018, BNP economists wrote in a report released last week. Within four years, the size of the balance sheet would fall to about $3.2 trillion. Rather than liquidating assets, the Fed would simply stop reinvesting payments from bonds currently held in the giant portfolio.
The impact could be stark. The asset roll-off would have the economic impact of two 0.25-percentage-point interest-rate increases per year, according to BNP. That's a steep acceleration from the recent pace of just two increases in the past two years.
Once it begins, yields on 10-year Treasury bonds could surge by almost 1 percentage point compared with short-term rates, the economists predict. Rates on 30-year mortgages probably would climb in tandem, potentially putting pressure on the housing market.
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 QE would also soak up excess liquidity from the banking system, helping the Fed to skirt tricky criticism over its payment of above-market interest rates on foreign lenders' deposits.
And by cutting its holdings now, the Fed could reduce the size of principal losses that might materialize as Treasury yields rise -- causing bond prices to fall.
Yellen said last month that such efforts would amount to a "passive removal of monetary-policy accommodation." That's Fed-speak for carting the punch bowl away while trying to keep the party going.
Of course, there's a risk that QT causes the markets to swoon -- similar to the "taper tantrum" of 2013, when former Fed Chairman Ben Bernanke signaled that the central bank was preparing to halt its post-crisis bond purchases. His comments in May of that year sent the S&P 500 tumbling by 7.5% in little more than a month.
On the positive side, according to BNP, the Fed would probably reduce its holdings of longer-term bonds before targeting those with near-term maturities. Doing so would help to alleviate upward pressure on the dollar, since foreign-exchange rates are typically more closely linked to short-term bond yields.
It would also offer a sop to President Donald Trump, who has stated his preference for a weaker domestic currency as a way to prop up exports and preserve U.S. manufacturing jobs.
Fed officials were reluctant to even ponder an asset reduction until recently. With rates set at zero in the years following the financial crisis, the reasoning went, officials would have little room to cut rates to bolster the economy if growth stalled. Now, as the Fed's own economists predict rates will surpass 1% this year, the chatter is growing.
Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said last month that officials should "start serious consideration" of reducing the central bank's balance sheet once rates reach 1%.
The following day, Dallas Fed President Robert Kaplan went further: "We should be debating probably in 2017 how we might begin to let the balance sheet begin to run off," he said.
The comments, taken in isolation, wouldn't be particularly noteworthy, Goldman Sachs (GS) economists wrote in a report last month. But in combination, they signal that Fed officials are "starting to fine-tune their views" on the topic, according to Goldman.
Partly as a result, questions about the Fed's balance sheet are starting to pour in from investors.
And for good cause.
"The effect on global markets with blowback to the U.S. could be unpredictable," the BNP economists wrote.
Yellen, the Fed chair, appeared to acknowledge that in a Senate Banking Committee hearing on Wednesday.
The Fed is reluctant to use adjustments to its balance sheet as a monetary policy tool, she said, preferring to rely on tweaks to short-term interest rates.
That's "our traditional tool," Yellen said, "and we have the greatest confidence in our ability to calibrate it relative to the needs of the economy."
Once short-term interest rates have climbed back to levels high enough that the Fed could use cuts to address any economic weakness, however, the central bank would stop reinvesting proceeds from maturing securities and allow the balance sheet to shrink "in an orderly and predictable way," Yellen said.
The monetary policy committee "will be discussing issues pertaining to reinvestment strategy to try to provide some further guidance" in the coming months, she added.