Fed economists map link between balance sheet and Treasury yields

SHRINKING the Federal Reserve’s bloated balance sheet to a more normal size, which may begin as early as this year, would lift the yield on 10-year Treasury notes by about an estimated 0.75 percentage point, according to a study by three economists at the US central bank.

The authors examined the impact of cutting the $4.5-trillion Fed balance sheet to $2.3 trillion over five years.

Remaining assets were estimated to continue to depress longer-term yields by about a quarter-percentage point more than would other have been the case.

Economists who follow the institution said the Fed was unlikely to pursue as rapid a pace of change as envisioned in the paper, because it would risk disrupting bond markets and might significantly reduce the number of times officials would otherwise increase interest rates.

“That seems like an aggressive unwind,” said Gennadiy Goldberg, senior US rates strategist at TD Securities in New York. “The majority of the impact would actually happen in the first couple of years, and that could be prohibitive.”

HYPOTHETICAL SCENARIO

Fed policy makers are contemplating when and how to shrink the central bank’s portfolio of Treasury and mortgage-backed securities. Minutes of their March meeting showed most officials favored a change later this year in the Fed’s policy of reinvesting holdings as they mature, which keeps the size of the portfolio level.

The paper, written by Brian Bonis, Jane Ihrig and Min Wei, doesn’t necessarily represent the view of Fed policy makers. The authors used a hypothetical scenario in which the balance sheet is trimmed enough to drain excess reserves deposited at the central bank by commercial banks, leaving about $100 billion in required reserves.

The start-and-end dates of the process were based on median expectations provided by respondents to the New York Fed’s December 2016 survey of primary dealers.

While the Fed’s approach to reducing the balance sheet remains undecided, officials have made clear they want to trim the portfolio without disrupting financial markets or supplanting the fed funds rate in the central bank’s monetary policy tool box.

“The exit from a large balance sheet should be conducted in ways that maintain the primacy of using short-term interest rates to either slow down or stimulate the economy,” Boston Fed President Eric Rosengren said April 19.

VERY DIFFICULT

It would be very difficult to calculate a speed limit for cutting the balance sheet while keeping to those two goals, said Luke Tilley, chief economist at money manager Wilmington Trust Corp. “There’s a considerable amount of uncertainty over how much impact it will have,” he said.

The Fed paper, in fact, makes that very point. The authors estimate that at the end of 2016 the balance sheet was suppressing 10year yields by 1 percentage point. But to make that same estimate with 90% confidence, they’re forced to place it in a range from about 0.5 percentage point to 1.5 percentage point.

“That’s about as wide a range as you’ll see for someone putting out research,” said Thomas Simons, an economist at Jefferies LLC in New York. “The chart shows, really, they have no idea.”

Moreover, even if the impact on yields were clear, it’s still uncertain how much the move in yields would corresponds to a movement in the fed funds rate — a calculation necessary to guess how much balance sheet moves might substitute for rate hikes.

For all those reasons, TD Securities’s Goldberg said, the Fed is likely to take more time than laid out in the paper to normalize the balance sheet, especially at the outset.

“We expect the Fed to have transition period in which it phases out the reinvestment throughout 2018 and possibly into 2019,” he said.