Last night the US Federal Reserve debated its $4.5 trillion balance sheet. This discussion has started to gain momentum with the change of politics on Capitol Hill at the end of 2016, and with one of the Fed governors William Dudley already indicating that 2018 may start to see a reduction of the Fed’s balance sheet.
Despite the end of Quantitative Easing being in sight QE “continues” here in the UK as well as in the US through the reinvestment of maturing bonds which has the effect of maintaining a static nominal balance sheet. That doesn’t hit the headlines as this is regarded as the small print and quietly forgotten – but it is material and going forward is up for grabs.
So for example, in 2018 the Bank of England will continue QE to the tune of £18bn as it reinvests maturing bonds. Policymakers to date have chosen to reinvest redeeming bonds in order to keep their nominal balance sheets constant – in the UK’s case £435bn of Gilts and in the US a total of $4.5 trillion. For the UK there is no plan or policy to reduce the amount of bonds held by the Bank Of England, but the Federal Reserve has pushed it up its agenda.
Previously, US Federal Reserve Chair Janet Yellen had suggested it was a secondary consideration, but with rates anticipated to be up another 0.5% by year-end, it seems like reducing the Fed’s balance sheet will become part of the policy mix. We see this as being a material part of likely policy and market debates over the coming months. Previously the bond markets had anticipated that the Federal Reserve would start reducing its balance sheet when short rates (Fed funds) were around 2%. It is likely that as short rates are pushed up we will also see the cessation of reinvestments. Being a reversal of QE is implicitly monetary tightening and may well help elongate the gentle rate cycle we currently see. It may also be part of the Fed’s desire to provide a natural counter balance to a more expansionary fiscal policy from the Trump administration. Either way this suggests the Fed continues to believe the US economy is gaining strength.