The Federal Reserve is about to embark on an epic shrinkage of its balance sheet, according to the minutes of its policymaking panel, released Wednesday. This is making the stock market uneasy. The S&P 500 dipped 0.97% yesterday and is off 0.45% this morning, in line with decreases on the other major indexes.
At the center of the market’s queasiness, along with ongoing worries about high inflation and the Ukraine war, is exactly how the balance sheet reduction will occur. The minutes only told us that the Fed will be reducing its holdings at a monthly pace of $60 billion in Treasury bonds and $45 billion in agency mortgage-backed securities. The point of the bond-shedding is to increase long-term interest rates.
Even the Fed’s chair, Jerome Powell, has indicated that a lot of question marks surround this campaign, known as quantitative tightening. “We have a much better sense, frankly, of how rate increases affect financial conditions,” he said in recent remarks.
“Even if it’s done in a predictable way, this is a big adjustment for markets,” says Brian Sack, director of global economics at the investment firm D.E. Shaw.
The general assumption is that the Fed’s bonds, bought to push down long-term rates amid the pandemic economic slide, will simply be allowed to mature. This would have an indirect impact on the bond market because fewer other investors would seek to purchase bonds, one theory holds. If the Fed actually sold bonds before maturity, that could suck liquidity out of the system.
This time, investors are well-notified of what the Fed is doing with its bond holdings. In 2013, then-Fed Chair Ben Bernanke shocked the market by announcing a big shift in policy.