Why the Federal Reserve’s Shrinking Balance Sheet Matters

By Mohamed A. El-Erian | Bloomberg,

The release on Wednesday of the minutes of the Federal Reserve’s March 15-16 policy meeting is generating a lot of discussion about the central bank’s plans to reduce its bloated $9 trillion balance sheet. There will obviously be implications for the economy and financial markets, but what precisely those will be cannot be determined with sufficient confidence yet. Inevitably, it will take time. Accordingly, here are some key issues worth thinking about in the weeks ahead:

Why It Matters

There is a simple yet insightful way to think about why and how the reduction in the Fed’s balance sheet matters.

Imagine that you are thinking about buying a home and you hear that the owner of many houses in the neighborhood is considering selling some. Imagine that this owner had doubled the number of houses it holds in just the last two years, buying them with little concern about price and value. And imagine that the owner will be equally as price insensitive in letting them go over time.

I suspect that you would think harder about whether you should buy your home now. Indeed, you would need a stronger reason to do so given concerns about valuations in the face of a large, persistent and noncommercial seller.

This is the situation the fixed-income market faces now that the Fed has signaled that it is considering reducing its balance sheet gradually and consistently at the rate of some $1 trillion a year.

A definitive plan has not been announced yet, and even when such a plan is in place, changes could be made in the size, pace and the balance between passive (maturities) and active (sales) runoffs. And the fallout of such a plan is complicated by the fact that the Fed will be raising interest rates simultaneously.

This is not just any rate-hiking cycle. With the Fed having already fallen well behind the curve on inflation, an increasing number of Wall Street analysts have ratcheted up their forecasts to include several 50-basis-point moves. The terminal rate is also moving higher, adding to concerns that, now that it is being forced primarily by its own decisions and inflation miscalls to scramble and play catch-up, the Fed may end up pushing into a recession an economy that, for too many years, has been conditioned to live with near-zero rates and ample liquidity injections. 

 The Impact on Markets

The absolute impact is clear. By reversing its role as a large, regular and noncommercial purchaser of government bonds, the Fed is calling time on its prolonged ultra-loose liquidity regime that heavily repressed yields across the government bond complex. As a stand-alone pricing influence, the impact could be quite pronounced given that the direct impact is accentuated by the likelihood that other actual and potential holders of the securities that the Fed intends to reduce will adapt their behavior.

While the short-term direction of yields is clear — segments of the curve steepened on Thursday, with 10- and 30-year yields rising to the highest level since 2019 — the size and timing of future moves are much harder to determine. The uncertainty relates to the other influences on government bond yields, including developments in the real economy.

Even more interesting is the relative impact.

So far, most of the other subasset classes in the fixed-income complex have handled higher and more volatile government yields relatively well. What remains unclear is whether such continued yield volatility will destabilize other risk factors such as credit, liquidity and market functioning.

Should that happen, stocks could also be impacted after having benefited significantly from Fed-induced conditioning that made valuations a function of TINA (there is no alternative to stocks), FOMO (the fear of missing out on yet another move higher for stocks) and, therefore, BND (buy the dip, regardless of its cause).

The Impact on the Economy

Traditionally, higher yields have influenced the real economy through three channels: affordability, wealth and risk sentiment.

The effects of the affordability channel, which are traditionally transmitted first and foremost through housing and cars, will be moderated this time by supply disruptions in the auto industry. Similarly, they will be tempered for companies given the extent to which many of them took advantage of ultra-loose financial conditions to extend their low-cost debt and reduce their carrying costs.

The indirect effects for both, however, will be strong given the increasing number of households and companies that are facing rising costs, particularly from high food and energy prices.

The wealth effect is something that is more uncertain. Undoubtedly, years of highly accommodative monetary policy pushed asset prices ever higher. The immediate reversal, however, is a function also of the extent to which investors are willing to think about absolute risks and not just relative ones.

This is related to general risk sentiment. There is likely to be an erosion, but the pace and extent will depend in large part on what happens in the country’s strong labor market.

Bottom Line

Even this narrow analysis of the effects of quantitative tightening highlights the multifaceted and fluid nature of the shift in the Fed’s liquidity paradigm. While significant uncertainties remain, there are also clear takeaways at this initial stage: The reduction in the Fed’s balance sheet is likely to be consequential, the broad contours of where the effects will be felt are clear, but the specific magnitude and timing are impossible to pin down now with a high degree of certainty.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include “The Only Game in Town” and “When Markets Collide.”

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