CLOSE LOOK
Shrinking the balance sheet - what’s the big story?

A reduction of the US Fed’s swollen balance sheet has long been debated and so far postponed. But what would such action entail and how could this impact the economy and financial markets? Fed Chair Jay Powell has confirmed that the process will start in early June, with all Fed committee members unanimous in their support. This could be a good moment to find out more.

The balance sheet has exploded since the Great Financial Crisis, when the Fed eased the crunch in lending conditions with a new tool known as quantitative easing or QE. Every month the Fed bought a pre-announced sum of US Treasury bonds, relaunching the programme at the time of the pandemic in 2020. The plan was always to reverse the process, but the total has now reached a towering $9 trillion.

Why does that matter? As the Fed creates and injects money into the financial system, it makes monetary conditions looser. That means more money washes around, potentially available for borrowing or investing. This naturally boosts demand and growth, but if uncontrolled could overstimulate the economy, possibly resulting in price inflation. Loose money also fuels financial markets, allowing them to become speculative or overvalued.

So how does the Fed achieve this shrinking? The first step could be to stop ‘reinvestment’. In previous years, as the bonds held on the balance sheet reached maturity and the capital sum was paid back, this money would be reinvested, thereby topping up the total. Now this rollover of the funds is likely to end.  There might eventually be outright sales of bonds. But not near term, as the adjustment is judged to be too abrupt.

What real-world effect could balance sheet shrinking have? The answer is that no-one knows. This QT or quantitative tightening experiment is also a first. One likely side effect will be an automatic tightening of monetary conditions in the US. Possibly even the equivalent of a full percentage point increase in interest rates. That could avoid some of the headline grabbing rate hikes that have spooked markets this year. And with inflation sticking above 8%, the Fed needs all the tools at its disposal.