How Does the Fed Reduce Its Balance Sheet?

Cutting the federal funds rate to near zero during the financial crisis, and the COVID-19 pandemic wasn't enough to bolster the economy and help return debt markets to their normal function. That prompted the Fed to embark on quantitative easing (QE).

The Fed's debt purchases lowered longer-term interest rates, giving the economy a tangible boost. They also signaled the central bank's determination to keep interest rates low, encouraging investment by increasing risk appetite in financial markets.

The Fed earned the reward of figuring out when and how to unwind at least some of those asset purchases. Managing the composition of its balance sheet and the effect of asset sales on financial markets and the broader economy remains a crucial Fed role.

Key Takeaways

  • The Federal Reserve's securities holdings reached $7.78 trillion in December 2023.
  • The Fed can reduce its balance sheet by electing not to reinvest some or all of the principal repaid when securities mature, a practice known as runoff.
  • The Fed can also sell securities ahead of the maturity date.
  • Fed balance sheet reductions reflect economic gains that are partly from previous Fed asset purchases.
  • In June 2022, the Fed began reducing its Treasury debt holdings by $30 billion and its mortgage-backed security holdings by $17.5 billion monthly, with plans to double those monthly cuts starting in September.
Total Assets of the Federal Reserve Banks

Understanding the Fed's Balance Sheet

The Federal Reserve's assets reached $7.78 trillion on Dec. 21, 2023. These assets included $7.24 trillion in securities held outright. U.S. Treasury securities, mostly notes and bonds, accounted for $4.79 trillion of the total. The Fed also held mortgage-backed securities (MBSs) worth $2.45 trillion.

Let's take a look at how the Fed got to this point.

The Fed Adds Assets

The Fed added assets worth approximately $2.8 trillion after the 2007-2008 financial crisis. The COVID-19 pandemic and the resulting financial panic impaired credit markets to the extent that the Fed was forced to buy more than $100 billion in securities daily during the worst days in March 2020.

The Fed eventually settled on a pace of $120 billion in monthly purchases, comprising $80 billion in Treasury debt and $40 billion in MBS. It increased its balance sheet by a total of $4.6 trillion in two years through March 2022.

In November 2021, the Fed began to reduce the pace of its purchases, bringing them to a close in March 2022. In May 2022, the Federal Open Market Committee (FOMC) said the Fed would reduce its holdings by:

  • $30 billion in Treasury securities
  • $17.5 billion in agency debt and agency MBS monthly starting in June
  • $60 billion in Treasury securities and $35 billion in agency debt and MBS monthly from September 2022

That faster rate of balance sheet reduction would put the Fed on pace to shrink its assets by $1.14 trillion annually.

Increased Balance Sheet Reduction

The FOMC said balance sheet reduction would continue until the point at which the balance sheet is just large enough to efficiently implement monetary policy, primarily by continuing to target the federal funds rate.

In a January 2022 statement on the principles of balance sheet reduction, the FOMC said the fed funds rate remained its primary monetary policy tool. It also aimed to do the following:

  • Reduce the balance sheet by adjusting reinvested amounts from maturing securities. This means the Fed planned to continue buying Treasury debt and MBS—just not as fast as the securities it now holds mature and are redeemed.
  • Primarily hold Treasury securities in the long run, "thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy."

The statement implied the Fed plans to eliminate its holdings of MBS over time. MBS purchases starting in 2020 helped to drive down mortgage rates, boosting housing demand, even as materials shortages and other market inefficiencies constrained supply.

Changes to the Fed's Plan

Changes were made to the Fed's plans to accommodate a change in previous economic circumstances. This was notable when efforts to shrink the Fed's balance sheet starting in 2017 foundered amid the COVID-19 pandemic.

The FOMC statements on balance sheet reductions in January and May 2022 noted details of the plan were subject to change based on economic and financial developments.

Quantitative easing is also referred to as large-scale asset purchases.

Balance Sheet Options: Reinvestment, Runoff, and Selling

The Fed's assets consist largely of debt securities, and like any bond portfolio it forces its managers to make choices as debt matures and the duration of holdings declines over time.

The Fed can reinvest all proceeds from maturing securities, or it can reinvest only a portion of the proceeds, as it chose to start doing in June 2022, in order to reduce the balance sheet gradually.

Fed assets would decline even faster if it chose not to reinvest any of the proceeds from matured securities, a tactic known as portfolio runoff.

Finally, if the Fed wanted to reduce the size of its balance sheet more rapidly than portfolio runoff would permit, it could sell some of its securities.

The Fed has an interest in ensuring its balance sheet reduction doesn't reverse the economic gains secured by the balance sheet's prior expansion. Partial reinvestment ensures the Fed remains a buyer of securities, while portfolio runoff doesn't add to their supply. Selling securities before they mature runs a greater risk of a significant increase in yields, the opposite of the effect of the Fed's asset purchases.

Whether sales are required to reduce the balance sheet depends on the desired reduction pace relative to the maturity schedule of the holdings. The Fed's asset purchases before the COVID-19 pandemic were mostly of long-term debt. After COVID-19 it bought securities of various durations, giving itself more flexibility to reduce those holdings through runoff.

The federal funds rate is a powerful tool that the Federal Reserve can use to help the economy when it's struggling. It can boost liquidity and the supply of credit in the banking system by lowering the overnight interbank lending rate.

Treasuries vs. Mortgage-Backed Securities (MBSs)

When the Fed buys debt securities, the buying drives up their price, thereby lowering the yield. When the Fed buys Treasury securities, the reduced yield produces debt interest savings for the U.S. government.

In contrast, when the Fed buys MBS, the resulting interest savings are eventually passed on to home buyers in the form of lower mortgage rates. Home buying, in turn, stimulates purchases of appliances and furniture, and supports a large home-building industry. As a result, reduced MBS yields stimulate the economy more directly than reduced Treasury yields. The smaller size of the MBS market relative to that of Treasury debt also means the Fed can move yields more dramatically per dollar spent.

Reductions in the Fed's MBS holdings will directly affect mortgage rates and through them the housing market and the broader economy. The FOMC's January 2022 reference to limiting long-term holdings to Treasuries so as not to affect the allocation of credit across sectors of the economy strongly suggests that's exactly the effect Fed policymakers attribute to the Fed's MBS purchases. The unavoidable implication is that at least some at the Fed feel it contributed to an overheated housing market between 2021 and 2022.

If the Fed moves from capping reinvestment in MBS to outright selling, the housing market is likely to feel the effect in the form of even higher mortgage rates.

What Are the Major Factors Affecting the Fed's Balance Sheet?

Several factors can affect the Fed's balance sheet. Economic conditions can lead the Fed to buy or shed its assets to make changes to its balance sheet. For instance, when the economy gets overheated, it may shed some of its assets to help facilitate a slowdown. Conversely, it may buy assets to boost its balance sheet when the economy slows down and/or there's a recession on the horizon.

Is the Fed's Balance Sheet Shrinking?

The Federal Reserve has been reducing its balance sheet on a steady basis. This move is known as quantitative easing. The goal of this move is to help cool down the overheated economy or stunt growth and fight inflation when prices get too high.

What Is the Largest Asset on the Federal Reserve's Balance Sheet?

The largest asset on the Federal Reserve's balance sheet is securities held outright. As of Dec. 21, 2023, the total amount held in this category was $7,24 trillion.

The Bottom Line

The shrinking of the Fed's balance sheet should be viewed as a victory, since only improvement in the economy's prospects is likely to bring it about. Because the Fed controls the U.S. currency, its balance sheet is practically limited only by the availability of assets and the Fed's preference for not usurping markets' role in setting securities prices and allocating economic resources.

By shrinking the balance sheet, the Fed runs the risk of reversing some of the benefits accrued by its expansion. But if the economy is truly on the mend, it's likely to weather gradual change in the Fed's securities portfolio.

Article Sources
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  1. Board of Governors of the Federal Reserve System. "The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates."

  2. Board of Governors of the Federal Reserve System. "Federal Reserve Balance Sheet: Factors Affecting Reserve Balances - H.4.1."

  3. Board of Governors of the Federal Reserve System. "Plans for Reducing the Size of the Federal Reserve's Balance Sheet."

  4. Board of Governors of the Federal Reserve System. "Recent Balance Sheet Trends."

  5. Federal Reserve Bank of New York. "Federal Reserve Asset Purchases: The Pandemic Response and Considerations Ahead."

  6. Board of Governors of the Federal Reserve System. "Federal Reserve Issues FOMC Statement, Nov. 3, 2021."

  7. Board of Governors of the Federal Reserve System. "Federal Reserve Issues FOMC Statement, Jan. 26, 2022."

  8. Board of Governors of the Federal Reserve System. "Principles for Reducing the Size of the Federal Reserve's Balance Sheet."

  9. Federal Reserve Bank of Dallas. "Fed’s Mortgage-Backed Securities Purchases Sought Calm, Accommodation During Pandemic."

  10. Reuters. "Sales of Fed's Mortgage-Backed Securities May Be Future Option, Williams Says."

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