By Lindsay (NYSE:) Dunsmuir

(Reuters) – The U.S. Federal Reserve will announce Wednesday that it will reduce its asset purchasing program starting in February. This would remove a first pillar for emergency monetary policy accommodations, which was introduced in March 2020 to protect the economy against the COVID-19 pandemic.

We will show you how and why the Fed reduced support for crisis-era crises and the implications that this has on the future size of the Fed’s balance sheet.

WHAT IS THE FED’S ASSET PURCHASE PROGRAM?

In a process called quantitative easing, the Fed has taken trillions in Treasuries since the start of the pandemic. The Fed uses this method to lower long-term rates, maintain financial conditions loose, spur demand and mimic the approach used in the aftermath to the 2007-2009 financial crises and recession.

The Fed currently purchases $80 billion of Treasuries each month and $40 billion worth housing-backed securities. From $4.4 trillion to $8.6 billion when the Fed began this program, its balance sheet has grown from $4.4 trillion to $8.6 Trillion. The Fed’s total assets include an $8 trillion stock of Treasuries, MBS and other securities.

WHY WILL IT STARTE TO TAP THOSE PURCHASES?

These extreme support measures are no longer necessary for the economy to grow at its fastest pace since 1980s. Keeping them in place might cause more damage than good. Low mortgage rates, for example, have contributed to a surge in home prices. However, the main problems facing the economy now are supply and demand issues. The bond buying process is already buoyant, with no signs of slowing.

They are doing this because the economy’s strong. Julia Coronado (ex-Feder economist, president of MacroPolicy Perspectives economic advisory firm), said that the economy is strong enough to stand alone.

(GRAPHIC: Get ready to taper – https://graphics.reuters.com/USA-FED/dwvkraoolpm/chart.png)

WHAT IS TAPERING?

The Fed will reduce its monthly purchases of Treasury securities by $10 billion each month and decrease the purchase of mortgage-backed securities to $5 billion by mid-November. They plan on phasing out all Treasury securities completely next June. According to Kathy Bostjancic (chief U.S. economist, Oxford Economics), the Fed does not stop bond purchases immediately “to avoid jolting markets and sending (market rate) rates higher than (naturally).”

Officials indicated that they expected the roll-off would run automatically, but can speed up or decrease the pace of purchases as needed. Tapering is expected to occur at an eight month pace, which is faster than the previous time. This indicates the Fed’s belief in the strongest recovery in years and the desire to move interest rates up from nearly zero next year in case of persistently high inflation.

WHAT NEXT FOR THE FED’S BALANCE SHEET POLICY?

The Fed will have a balance sheet of just over $9 trillion by next June. About $8.4 trillion will come from bonds that were associated with QE rounds dating back more than 10 years ago. What will happen next?

Two years ago, Fed officials began to reduce its balance sheets by shrinking it after they raised its primary short-term interest rate. This rate is also called the Fed funds rate. Securities are not replaced as they age. Fed observers think that the central banks will continue to be passive and patient this time, due in part to the fact it has reduced its balance sheet by too much for 2018-19.

This led to a surge in bank reserve demand, which caused volatility in the short-term money market. The Fed made a U-turn and increased its balance sheet to help improve the functioning of the financial markets.

(GRAPHIC: Fed balance sheet by era Fed balance sheet by era – https://graphics.reuters.com/USA-FED/TAPER/xmpjolmanvr/chart.png)

But it will reduce its balance sheet, right?

Not necessarily. Because of some reservations about the Fed’s untested policy tool, last time they were focusing on shrinking its balance sheets. Coronado stated that after using their balance sheet twice as the main policy plank since the Great Recession, “officials now know it will be out next recession and it will be a tool for the toolkit.”

Fed Chair Jerome Powell already suggested that we just keep the balance sheet stable and allow the economy to grow. In order to exert less control over the economy’s growth, the balance sheets would actually shrink in percentage as GDP grows. As a percentage of nominal GDP, the total balance sheet is almost 36% now. This is roughly double what it was prior to the pandemic.

Others disagree, saying that too big a permanent balance could hinder its effectiveness during upcoming recessions and may compel the Fed to decrease its size. These numbers don’t matter what perspective you take… It is possible to ‘normalize’ certain policy instruments over the course of time. Matthew Luzzetti is the chief U.S. economic advisor. Deutsche Bank (DE:).

What do FED POLICYMAKERS STAY?

Few policymakers have yet to make a decision. Last month, Fed Governor Christopher Waller called for the shrinking balance sheet and letting matured securities go. This is similar to what happened last year. Esther George, Kansas City Fed president said that the Fed could want to maintain longer-term rates at a low level by maintaining a large balance and counteract this stimulus with a higher Fed Funds Rate. However, this could increase the chance of an inverted yield curve. George said that balance sheet shrinking would be an argument to lower rates. This is a perfect example of the dilemma Fed officials will face in months ahead.