By Howard Schneider

WASHINGTON, (Reuters) – The U.S. Federal Reserve will provide more information on its three-year-old plan to reduce several trillion dollars in assets that were purchased to stabilize financial markets during the coronavirus epidemic. This is the next step of the Fed’s move to lower inflation and tighten credit.

Officials say that the reductions could start as early as next month. Minutes of Fed’s March session were released at 2 pm (1800 GMT). This may give an indication of how quickly and far the Fed will go to get rid of $4.6 trillion worth of U.S. Treasuries, mortgage-backed securities, and other assets accumulated between March 2020 and March 2020.

Economists estimate that the Fed is already shedding between $80 billion and $100 billion per month due to rising interest rates for home mortgages, bonds, and longer-term debt. This may explain why the market reaction might be slow.

The plan, however, will be a strong signal that officials intend to increase credit costs and help reduce inflation, which is currently at over triple the Fed’s target of 2%.

Lael Brainard, Fed Governor and nominee for Vice-Chair said Tuesday that the Fed will “continue tightening Monetary Policy methodically through interest rate increases as well as by beginning to reduce balance sheet at an accelerated pace as soon as we meet in May.” Brainard referred to 2017-2018 period in which the Fed had to reduce its holdings by $50 billion per month. He said that “I expect the equilibrium sheet to shrink significantly more quickly” at this point.

The central bank increased its federal funds target rate by 25% last month. This was the beginning of a series of anticipated hikes in this year’s and next years.

According to Fed officials, six quarter-point more increases were expected this year. Minutes may provide some insight into the debate. However, it appears that Fed officials have already begun shifting their views in favor larger hikes of half-point at one or two of their sessions. Federal funds futures contract traders anticipate that the Fed will increase the pace of tightening at the next three meetings by half-points. It could prove to be one the most rapid tightening cycles in history, at least since the 1960s.

For a related graphic on The Fed’s last windown: Treasuries, click https://tmsnrt.rs/3uWX0cf

‘FULLY PRICED’

The Fed’s shrinking balance sheet increases credit market pressure by decreasing the demand for its assets, which in turn puts upward pressure on interest rates. Though estimates are not exact, Fed Chair Jerome Powell stated after the March meeting that the Fed might see the same effect from a quarter point increase in its short-term rate.

Lorie Logan is a New York Fed market officer and estimated last month that the Fed would lose an average $80 billion per month in Treasuries if it didn’t reinvest the monthly payments on its assets.

Analysts expect a smaller amount, however, absent a surprise Wednesday, “the market has fully priced” the Fed’s ability to shrink its balance sheet by maybe $3 trillion in three years. Joe Brusuelas, RSM chief economist, stated that there is no major shock.

He said that details of the plan as well as the language used by Brainard and other people at the moment “appear to be designed at keeping (inflationary) expectations anchored”. This is done through the implementation on the shift which officials have publicly discussed since last autumn.

Powell presented the basic contours when he said to Congress last month that in the next three years, the Fed will “increase its asset holdings relative to the economy to the size it was prior to” the pandemic.

After the 2008-2009 financial crisis the Fed accumulated $4.2 trillion worth of assets through several rounds “quantitativeeasing”, which was roughly 24% U.S. gross domestic products. It reduced its holdings by 16.5% from GDP between 2017 and 2019.

For a related graphic on QE, QT and GDP, click https://tmsnrt.rs/3x6ioOQ

IN THE BACKROUND

There is more going on at the moment. Between March 2020 to March 2022, the Fed managed its Treasury and mortgage assets up to $8.5 trillion. This is roughly 35% GDP. Some elected officials were concerned that this level would push the Fed too far into government finance and financial markets.

The Fed may begin to withdraw its reserves as economists anticipate it will end up aiming for a balance level equal to maybe 20% GDP or about $6 trillion. This depends on how quickly the economy expands and what reserve level commercial banks need.

The policymakers said that they don’t want to make the same mistake as 2019 when the balance sheet was so small, it caused banks to charge one another a higher interest to borrow funds. The Fed was forced to inject more cash into its system as a result.

Andrew Patterson, Vanguard’s senior international economist said that they want the program to work in the background and would be careful with the language used.

Patterson stated that he believed the Fed would reduce its balance sheet to “20ish”% of GDP. However, it may take up to four to five years, which is slightly slower than Powell suggested to Congress.

John Williams, New York Fed President, stated Saturday that no matter what the conditions are it will take an economic shock to make the economy change its course after agreement has been reached.

Williams explained that Williams suggested the following: “The initial phase should have the program operate in a predictable manner in the background.”

For a related graphic on The Fed’s potential drawdown, click https://tmsnrt.rs/3LMHaI7