Fed Minutes from Mid-March Meeting Point to the End of Reinvestments Later This Year, Beginning the Long Process of Fed Balance Sheet Normalization
In the March 14-15 meeting round, the participants discussed at length the approach by which they may begin unwinding the Fed’s $4.5tn balance sheet. On the whole, they generally agreed that continuing reinvestments in past years allowed a "smooth and effective" conduct of monetary policy. They also reiterated the principles outlined in their September 2014 plan of ending reinvestments which consisted of: gradual and predictable approach while primarily relying on passive phasing out of reinvestments, while highlighting that the target for the federal funds rate should remain their key policy tool.
The FOMC also discussed conditions under which the Fed could adopt another bond buying program. Any such circumstances would have to be substantially adverse as far as economic terms, in that they warranted greater monetary accommodation than could be afforded by the fed funds target given its lower bound.
Triggering the end of reinvestments, and therefore the beginning of normalization of the balance sheet, was viewed by several participants as being tied to a quantitative trigger, such as the level of the fed funds rate target, while others argued for a more qualitative approach which would consider the outlook and risks also.
Having said that, most members viewed that should the economy performed as expected, the change in reinvestment policy should come about this year, with passive and predictable decline in the size of the balance sheet. On the other hand, should the economy falter, and require a lower fed funds rate target, reinvestments could once again be utilized to provide support.
The Committee appears to prefer to end reinvestments in both Treasuries and agency MBS just the same. A phase out of reinvestments could be beneficial in reducing financial volatility, while an all-at-once ending of reinvestments was seen as easier to communicate and allowing for quicker normalization.
The Committee was unanimous in ensuring that any policy change was well telegraphed to the public, with information about the Committee’s expected future size and make-up of the Fed’s portfolio also seen as helpful.
As far as the target for the federal funds rate, the Committee continued to expect that with gradual adjustments in the rate, the economy would expand and labor conditions tighten further, pushing the Fed’s inflation rate target towards the 2% goal. While uncertainty was a theme across the discussion, near-term risks were viewed as balanced given the plethora of domestic and foreign risks which could both support or drag economic activity relative to baseline.
Key Implications
Given the lack of substantive changes as far as outlook, the minutes from the mid-March meeting were largely scoured for clues about balance sheet normalization – something we’re heard many Fed officials talk about louder in recent months.
Overall, the discussion didn’t really alter our views as far as how the Fed will proceed. It appears that both Treasuries and MBS will cease to be reinvested, with some pressure on yields across those markets when as reinvestment timelines are announced. Still, while there is debate amongst the committee, we expect a taper of reinvestments is likely to be employed instead of the one-and-done approach advocated by some. This view is based on the notion that any potential costs of unnerving markets outweigh the any benefits of cutting it off abruptly – still this isn’t yet decided and we look forward to more communication in the coming months.
Overall, we expect the Fed to hike twice more this year, with 25 basis point hikes likely coming in June and September. Subsequently, the Fed will lay out and implement the beginning of the end of reinvestments. Instead of reinvesting 100%, as it does now, the Fed could reinvest 80%, then 60%, etc. until reinvestments were no more. At that point, the balance sheet would passively begin to shrink, all the more so relative to the growing American economy.
