Economic and financial conditions improved considerably. Therefore, the Federal Open Market Committee (FOMC) started on a path of gradual interest rate increases in December 2015 and in October 2017 began the process of shrinking the Fed’s balance sheet. Here is a look at how the Fed’s balance sheet holdings can affect a broad range of financial conditions, including interest rates.
What is the size of the Fed’s balance sheet and what does it include?
The Federal Reserve’s balance sheet has grown from about $900 billion to almost $4.5 trillion over the past decade. The balance sheet is audited annually by an independent audit firm and is available to the public on the website of the External LinkFederal Reserve System’s Board of Governors.
The Fed’s assets mainly include a securities portfolio of System Open Market Account (SOMA) holdings. Prior to the use of LSAPs these assets consisted primarily of shorter-dated Treasury securities. Now the SOMA portfolio mainly comprises longer-dated Treasury securities and agency mortgage-backed securities. The Fed’s liabilities mainly consist of Federal Reserve notes in circulation (currency) and depository institution deposits (reserve balances).
What will happen to interest rates now that the Federal Reserve has started to shrink its balance sheet?
The use of LSAPs lowered long-term interest rates by increasing the price of the assets the Fed purchased. For most assets, buying and selling by one investor is unlikely to affect the price. But given the sheer size of purchases made by the Federal Reserve, research suggests the FOMC was successful in increasing the price of the government and agency debt that it purchased. Since bond prices and yields move in opposite directions, the higher price equated to lower interest rates. Shrinking the balance sheet in a predictable manner over the coming years is expected to gradually reverse these price increases. In other words, interest rates are expected to modestly rise as the Fed shrinks its portfolio of bonds.
What is the outlook for the Fed’s balance sheet?
The Federal Reserve’s plan for reducing its balance sheet is to gradually allow maturing securities to roll-off each month. In other words, the FOMC doesn’t plan to sell the securities on its balance sheet. To achieve a gradual and predictable reduction in its balance sheet the FOMC has put pre-set caps on the amount of securities that are allowed to roll off each month. Guidance from the FOMC indicates that the balance sheet will be smaller than it is now but larger than it was before the crisis.
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