FOMC Minutes: Continued Talk of Balance Sheet Strategy

By: C.Jay Engel

The minutes from the March FOMC meeting were released yesterday and we discover that the balance sheet theme is really coming together. The massive portfolio held by the Fed is allegedly going to be reversed over the coming years. The way to initiate this shrinkage in the balance sheet is to first stop reinvesting the return that it is making on all the bonds it holds. In the minutes, we learn that they are considering two options for how to do this:

An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee’s policy intentions while only modestly slowing reductions in the Committee’s securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet.

Option 1: “gradual” phasing out of the level of reinvestment. Option 2: immediate halting of any reinvestment whatsoever.

These are going to be the debated options moving forward in the coming FOMC meetings and Fed members speeches. The Fed tends to prefer “gradual” approaches to things, keeping at the forefront of their mind the possible reactions (temper tantrums) by stock and bond market participants. If they decide to begin phasing out interest rates, it will be much later this year. This gives them two quarters in the meantime to conduct two more rate hikes.

The FOMC minutes give suggestion that, as they are trying to get back to “normal” interest rates and balance sheet levels, they are going to be going back and forth between their two methods: Fed Funds rate hikes and slowing reinvestment. While watching paint dry has been more exciting than their rate hike progress, it seems that the Fed is going to be another two years before they get the Fed Funds rate into the 2% range (if they can make it that far) if they alternate between a reinvestment policy change and a Fed Funds hike.

Of course, all this could come unraveled by a single poor employment report. The wizards determining the direction of our economy, are actually as blind as anyone else. They are walking on eggshells, unsure what to do and where to do next. How does one reverse an 8-year 400% increase in the central bank’s balance sheet without causing a commotion? That would be impossible. 

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