Jonnelle Marte, Dan Burns

(Reuters] – The Federal Reserve has indicated that it is willing to reduce its bonds holdings by more than $8 trillion. This was evident in a report of last month’s U.S. central banks meeting, which suggests the process could begin later in this year.

It demonstrates a major difference between how Fed handled its policy “normalization”, which was after the 2007-2009 financial crises, and an even faster removal of extraordinary accommodations than before. This also indicates that officials are more optimistic about the economic recovery following the coronavirus pandemic, than they were after the recession over a decade.

After the December 14-15 Fed policy meeting, Jerome Powell stated to reporters that they may be able move faster than ever before when it comes shrinking the balance sheets. He noted that officials have a “significantly different economic environment” from what we currently see.

The minutes of the meeting were released Wednesday showing that officials engaged in lengthy discussions about shrinking central bank’s balance sheets. This could potentially have a significant effect. Bond yields are rising as bond maturities that respond to Fed signals about interest rates, and the balance sheet are sensitive have pushed them higher in financial markets.

1) WHY ARE THE FED’S ASSET HOLDINGS IMPORTANT?

When the financial crisis of 2007-2009 erupted, it became clear that cutting short term interest rates was not enough.

Although it was difficult to do so, buying tens or billions of dollars in Treasuries at the time of mortgage-backed securities and Treasuries helped reduce longer-term borrowing costs for households and businesses. It also helped repair a damaged credit market and promote an economic recovery.

Between 2008 and 2014 the Fed had accumulated $4.25 trillion worth of bonds. The yield of the U.S. Treasury 10-year note (which is used to determine rates on all types of loans including car loans and home mortgages) had dropped from above 4 to 2 percent.

The coronavirus pandemic in 2020 caused panic across the financial markets. Fed responded again with huge bond purchases and interest rate reductions. The Fed’s total bondholdings are now $8.3 trillion. It has approximately $5.65 trillion of Treasuries, and about $2.65 trillion MBS. About a quarter (25%) of the Treasury market is itss.

2) WHY DO OFFICIALS WANT MORE AGGRESSIVE ACTION THIS TIME?

Officials at the Fed say that the U.S. is stronger today than during previous policy relaxation periods. Officials are keen to ensure they can respond to inflation well beyond their target of 2%. The December meeting minutes show that officials are encouraged by improvement in the labor markets and believe they’re close to their maximum employment goal. The Fed would not be needed as often, this would indicate.

Many policymakers worry that rising asset prices could also be caused by the Fed’s huge balance sheet and policy of keeping interest rate at an extremely low level. The pandemic saw home values rise as people tried to take advantage of low mortgage rates in order to get out of densely populated areas. The equity market has reached record levels, and officials don’t wish to be seen encouraging unwelcome asset bubbles.

3. WHAT HAPPENED WHEN FINANCE REDUCED IT’S BALANCE SHEET THE LAST TIME?

After the Fed ended adding more bondholdings to its portfolio at the close of 2014, the Fed initially delayed reducing its balance sheets for several years. However, this was even though it had raised interest rates in the late 2015. Officials considered the recovery in that period to be much more soft than the recent rebound from the deep, but brief recession of early 2020.

In 2018, the central bank began shrinkage. This allowed a limited number of bonds to mature per month, with the principal not being reinvested. It was a process known as quantitative tightening or QT. By September 2019, $650 million of bonds were rolled by the Fed. This happened after a short-term credit market crash that caused a significant amount to be withdrawn from the system.

Minutes from last month’s Fed meeting show that Fed officials felt the pace at which its balance sheet reduction should be accelerated was faster.

4) THE END OF QT 4 MET WITH UPHEAVAL AT A KEY MARKET. IS THAT AN EXPECTATION?

2019 saw a decline in the Fed’s reserves. The short-term cash shortage caused a rise in borrowing rates, which required the central banking to intervene on money markets in order to preserve their functionality.

Many financial firms are now dealing with the opposite problem – too much cash. A new tool that the Fed has created is called “standing repo facilities” (or SRF). This can act as a backup for businesses that have run out of cash. However, it was never used in a QT setting.

Fed officials still remain unsure of how far they are able to drain reserves. The Fed said that it will continue to monitor the money markets for signs indicating a liquidity crisis as it shrinks its bond holdings.

According to minutes, some officials still believe that the SRF can lower reserve demand, which could lead to a smaller balance than it would have been without this tool.