Fed Rate Increase As Expected; Shrinking Balance Sheet Much More Interesting

As expected, The FOMC (Federal Open Market Committee) of the Federal Reserve raised the Fed Funds rate by 1/4-point to a range of 1% to 1.25%. They further projected that one more rate increase will be needed this year. This is all pretty much as was expected (the futures were indicating a 99%+ likelihood on a 1/4-point raise). What was much more interesting is that the Fed now plans to (finally) shrink its balance sheet. Prior to the Great Recession, the Fed’s balance sheet contained about $800 billion in securities. Following the Great Recession, to add stimulus to the economy, the Fed expanding its holding to $4.5 trillion, primarily in treasuries, mortgage-backed securities, and other agency securities. To maintain the value of this portfolio, the Fed has been reinvesting the proceeds from all bonds that mature. In yesterday’s statement, the Fed indicated that they will reduce their reinvestment of proceeds by $6 billion per month for treasuries, and by $4 billion per month for mortgage-backed and agency securities.

Further, each quarter, they will decrease reinvestment in treasuries by an additional $6 billion per month, and an additional $4 billion per month for mortgage-backed and agency securities. This amounts to a total of $10 billion per month for the first quarter, $20 billion per month for the second quarter, and so on until they get to $30 billion for treasuries per month and $20 billion for mortgage-backed and agency securities ($50 billion in total per month). It is not clear how long they plan to undertake these actions, or what their ultimate target is for the total securities portfolio is, but this is a significant departure for the Fed. Their intention with these actions is to reduce the upward pressure on bond prices that their consistent buying has caused, thereby lowering prices, increasing rates, and taking cash out of the economy. In essence, they are tightening monetary policy, which should increase interest rates and slow economic growth (somewhat).

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