Fed raises rates by 0.5%, will shrink balance sheet

WASHINGTON — The Federal Reserve raised its benchmark federal funds rate by half a percentage point and will begin the process of reducing its balance sheet next month as it ramps up its efforts to rein in inflation.

Both moves, announced Wednesday after the Fed’s Federal Open Market Committee meeting, were signaled during its previous meeting in March and broadly expected. It’s the largest single rate increase since 2000 and the first time since 2006 that the FOMC has raised rates at two consecutive meetings.

Federal Reserve Chair Jerome Powell said that additional 0.5% rate increases are possible in future meetings, but downplayed the potential for even larger rate hikes, saying that 0.75% rate hikes are “not something the committee is actively considering.”

The Fed said it would begin allowing $47.5 billion of securities to run off its balance sheet monthly starting in June. It will then increase its reduction cap to $95 billion in September. Powell said during a press conference following the meeting that the FOMC’s balance sheet decisions are “guided by our maximum employment and price stability goals” and added that the committee will “be prepared to adjust any of the details of our approach in light of economic and financial developments.”

The Federal Reserve’s Federal Open Market Committee Wednesday voted to raise the federal funds rate by 0.5%, the largest single rate increase since 2000.

Bloomberg News

While increasing the federal funds rate will have a more immediate impact on banks by increasing overnight reserve loan interest rates, the Fed’s effort to reduce its balance sheet could have the more lasting effect according to Greg McBride, chief financial analyst for the aggregation site Bankrate.

“Downsizing the balance sheet is probably going to be more impactful than raising short term interest rates,” McBride said. “Raising short term interest rates is much more in-your-face and transparent; downsizing the balance sheet is more behind the scenes, but that’s the one that’s going to have the more pronounced effect economically.”

When the Fed sheds assets, it also reduces its liabilities, which include reserves held for member banks, Derek Tang, co-founder and economist at Monetary Policy Analytics, said. With fewer reserves available to them, banks will have to make decisions about how to manage their own assets and liquidity needs.

“In an environment where reserves are really ample, you don’t necessarily have to consider that question,” Tang said. “But, if there are less and less reserves in the system, you’re gonna start to think okay, well, what do I need in terms of my balance sheet planning needs?”

The last time the Fed began shrinking its balance sheet, a process known as quantitative tightening, was between 2017 and 2019. The Fed reduced its holdings from roughly $4.4 trillion to less than $3.8 trillion before it began growing its holdings again during the fall of 2019. 

Along with keeping interest rates at their lower bound, the Fed has supported the economy by purchasing Treasury securities as well as securitized mortgages from government sponsored enterprises Fannie Mae and Freddie Mac. Between March and June 2020, the Fed’s holdings ballooned from $4.2 trillion to $7.1 trillion. The balance sheet has swollen to more than $8.9 trillion as of April 27.

The Fed’s buying spree has provided liquidity to financial markets by increasing the availability of credit and thus keeping borrowing costs low. Yet, critics say the continuation of this activity long after the initial shock of the pandemic has fueled asset price inflation and driven up housing costs. 

Powell addressed those concerns during the press conference by saying that the tools available to the Fed are notoriously imprecise, and some economic pain could very well accompany rate hikes. But that pain is in service of re-establishing price stability while avoiding a full-blown recession.

“We have essentially interest rates, the balance sheet and forward guidance, and they’re famously blunt tools — they’re not capable of surgical precision,” Powell said. “So I would agree, no one thinks this will be easy. No one thinks it’s straightforward, but there’s certainly a plausible path to this.”

The Fed began to slow down its asset purchases — a process known as tapering — last November. It had dialed down its monthly purchases pace of Treasuries and MBS from $80 billion and $40 billion, respectively, to $60 billion and $30 billion, with the goal of getting to a stable level by the middle of this year. 

After the March FOMC meeting, the committee agreed to begin shrinking its balance sheet in the near future. Typically, this is done by allowing assets to reach maturity and not replacing them with new investments. On Wednesday, the Fed said it would allow $30 billion of Treasury securities and $17.5 billion of agency MBS to run off monthly between June and August. Those caps will double from September onward. 

Should the Fed want to accelerate the rate of its balance sheet reduction further, it could sell assets into the open market, but there is no precedent for that. Yet, there is also no precedent for the Fed’s balance sheet being as large as it is. 

“The size of the balance sheet went from about one-fifth of the nominal economy [before 2020] to about 40 percent of the economy, so it doubled in real terms,” Tang said. “The Fed wants to get it back down to a level that’s a little bit more politically acceptable so that if they do have to expand again at least they’re starting off from a lower starting point.”

Comments are closed.