How the Fed’s Balance Sheet Reduction Could Thwart Easing of Policy Rate

The Federal Reserve is shrinking its balance sheet, which it had pumped up during the 2008-09 financial crisis and then amid the height of the pandemic in 2020, as it sought to stabilize the bond market and plug cash into the U.S. economy. Now the central bank might change its reduction strategy—and that could impede plans to lower interest rates, per research from asset manager BlackRock Inc.

This question comes as the Fed mulls over whether to cut its short-term benchmark rate, to forestall an economic downturn. Continued reduction in Fed bond holdings could hinder such an effort if long-dated bonds, now largely kept on the books, were ditched, as well.

Some history: By buying Treasury bonds and mortgage-backed securities, the Fed expanded its holdings to a peak of almost $9 trillion in mid-2022, from $0.9 trillion at the end of 2007 and $4 trillion at the start of 2020. Since then, mainly through letting some fixed-income securities mature, it dipped to $7.2 trillion last month.

The Fed has not indicated when it will end the runoff or at what level. “The Federal Reserve’s balance sheet is one of the world’s most important security portfolios, yet its ongoing importance for markets and financial conditions is often underappreciated.” declared the BlackRock study, titled “QT-Lite: Quantitative tightening’s limited impact.”

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A little-known fact is that the Fed has disposed of more short-term securities and let more long-dated bonds remain, an allocation that exerts “a powerful downward force on bond yields,” according to the study, led by Tom Becker, portfolio manager on BlackRock’s global tactical asset allocation team. That is the equivalent of the Fed’s dropping rates two percentage points, below the present band of 5.25% to 5.5% for the fed funds rate, the report found.

Meanwhile, the Fed’s portfolio still contains more than 30% of all of outstanding long-term Treasurys, meaning with terms of 10 years or longer, the BlackRock paper reported, “thereby removing a significant amount of the supply of long-dated government securities and creating scarcity.”

The relative scarcity has helped push up long-term bond prices and thus pull down their yields. The 10-year’s yield fell to 4.4% on Monday from 5% in October 2023. (To be sure, other factors are involved with the yield, such as ongoing high inflation, which can increase yields.)

The Fed has continued to reinvest the proceeds of some maturing bonds in excess of the monthly targets for expiration, mainly long-dated ones. In 2023, those rollovers totaled $860 billion, meaning that the Fed purchased nearly 10% of the new supply of 10- and 30-year bonds at Treasury auctions last year.

These actions, the BlackRock report noted, help “to explain the resilience of the economy to the policy tightening of 2022 and 2023, as well as continued inversion of the U.S. yield curve,” where low-maturity paper yields more than longer-dated issues.

But what if the Fed chose to let longer-dated bonds expire, or even sold them? That would remove downward pressure on long yields, which affects, among other things, home mortgage rates.

The BlackRock paper contended: “Though the likelihood of any policy changes happening this year are exceedingly low, we think the risks for a tightening from balance sheet changes could grow once we get through the U.S. elections in November.”