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US Fed On Course To Reverse Quantitative Easing

The FOMC released its meeting minutes on 6 April 2022. There are only 2 notable points. The first is that many members actually preferred a 0.5% hike in March. Whether the word "many" implies majority, we do not know, but in light of Russia's invasion of Ukraine, they settled on 0.25%. The second is that Fed is finally embarking on a much-expected plan to trim its balance sheet again.

What does trimming the balance sheet mean?

Since 2008, Fed has aggressively pursued quantitative easing to increase money circulating in the system. The aim is to stimulate the recovery of the economy. To do that, they keep buying a range of Treasury and mortgage-backed securities to release their money into the system.

US Fed Balance Sheet Holdings
US Fed Balance Sheet Holdings (Source: FRED)

This is not some trivial amount we are talking about. If you look at their balance sheet before 2008 and now, you will appreciate the difference. Prior to 2008, they hold about $1 trillion in assets on their balance sheet. Today, that amount swelled close to $9 trillion. Most of these are long-term Treasury notes or bonds and mortgage-backed securities.

So when they say they are going to trim the balance sheet, that means they are going to reduce these holdings. And how will they do it? They simply let the securities mature and will not reinvest the proceeds to replace these securities. That is what it means when you see news saying "Fed is planning to run off XX billion of Treasuries" etc. At the moment, Fed intends to "run-off" up to $60 billion in Treasuries, and $35 billion of mortgage-backed securities a month. Why not just sell their holdings in the market? Because this is a much more aggressive approach that is likely to push down bond prices sharply.

But of course, things are not that straightforward. With monetary policy, things will always be fluid and change according to prevailing conditions. This is also not the first time Fed attempted to reduce its balance sheet. They did that in 2017 but had to stop it in 2019 as the economy shows signs of buckling.

Where Is The Fed Funds Rate Going Now?

Fed Funds Rate Expectations (6 April 2022)
Fed Funds Rate Expectations (6 April 2022)

Fed Funds Rate Expectation Change
Fed Funds Rate Expectation Change

The Fed Funds rate expectations rose after the release of the minutes. The market has been pricing in an increasingly more aggressive path. With no end in sight for the Ukraine-Russia war, concerns about stagflation, and a Fed that keeps upping its hawkish tempo, this seems in line.

Based on what the Fed Funds futures are showing, the market expects a half percentage hike for each of the next three FOMCs. And we will end the year with Fed Funds rate hovering around 2.76%.

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