Stimulus Unwind Targets Fed’s Balance Sheet

Two hikes or three. Maybe less.

On Wall Street, the guessing game over the last several months has been predicated on the “will they or won’t they and when” of rate hikes from the Federal Reserve through this year and beyond.

The recent focus has been on the size of the Fed’s balance sheet, which soared in the wake of the financial crisis. The balance sheet is at $4.5 trillion, on the heels of three separate forays into bond purchasing. As reported by Bloomberg earlier in the week and minutes from the Fed meetings last month, the mindset seems to be one that will reduce the size of that asset-heavy sheet, perhaps even ahead of further rate increases. Commentary noted that the trimming should be “gradual and predictable” with a timeframe of “later this year.”

That does not give any indication of how and when and just where the cuts will take place. The federal funds rate, as always, will remain the significant lever (and harbinger) of interest rate increases, should they be in the offing. But could it be the case that balance sheet cuts will take precedence over interest rate policy?

Bloomberg noted that central bankers have “penciled in” and also set market expectations for three rate hikes through the next several months (one has taken place this year, in March). Three may be a stretch, if interest rates really start to take off, in the wake of jobs numbers and wage hikes, and if the balance sheet changes, it may in fact lead to higher rates, too. Investors, said Bloomberg, have taken their own guesstimates of hikes from three hikes to something on the order of half that amount.

The Treasurys and mortgage-backed bonds that were bought by the Fed through the financial crisis and its aftermath came in an effort to keep rates low and stimulate the U.S. economy. The timeframe will have to be a gradual one, with years, not months, needed to complete the unwinding.