Fed's balance sheet plans could take center stage this week

By Michael S. Derby

NEW YORK (Reuters) - An announcement from the Federal Reserve to kick off the end game for its balance sheet runoff could come as early as this week's policy meeting, a number of economists say, though an uncertain outlook for interest rates amid sticky inflation could push a "tapering" declaration back to June.

Tapering involves slowing the pace of the Fed's quantitative tightening program, under which it has been allowing up to $95 billion a month of Treasuries and mortgage bonds to mature from the central bank's portfolio and not be replaced. Fed officials have been signaling they would soon like to slow QT, noting that by downshifting the pace they can reduce the risk of market stress and perhaps shrink its holdings by a greater degree.

The Fed has been cutting the size of its balance sheet since June 2022 after doubling it to $9 trillion in the wake of the onset of the coronavirus pandemic, as it sought to stabilize markets and provide stimulus to the economy. The Fed fired up QT as it raised interest rates aggressively to bring inflation back to its 2% target.

Fed bond holdings have dropped to around $7.5 trillion, and while it has not specified where it wants holdings to end up, the central bank is seeking a level of market liquidity that fosters limited interest rate volatility and allows it firm control over the federal funds rate, its main tool for achieving its policy mandates. A recent New York Fed report said it’s likely the QT process will run into 2025 before holdings level off.

Minutes of their last meeting in March signaled officials favor a QT taper that focuses only on slowing the runoff of Treasuries, as mortgage bonds have been expiring at well below their $35 billion a month target, and ultimately they'd prefer only to hold government bonds.

“The next step in the Fed’s balance sheet reduction plan is pretty clear: cut the monthly cap on Treasury runoff from $60 billion to $30 billion,” J.P. Morgan economists said in a research note. “The only real question is when: at the May meeting or at the June meeting."

"We lean toward (May),” they said, as it is a meeting with no expectations for a change in interest rate policy, and no policymaker forecast updates.

The Fed has gone to lengths to separate its balance sheet and interest rate policies, though both have worked in the same direction to make Fed policy overall more restrictive.

Wrightson ICAP analysts also see a QT taper announcement at the end of the Fed's two-day policy meeting on Wednesday as “there is also no obvious reason to wait.”

Bank of America economists also believe the Fed will announce a runoff slowdown this week because it will help it manage liquidity needs stemming from how banks and the Treasury manage cash flows.

SUMMER START?

But others see the can kicked down the road a month.

“In a close call, we now expect an announcement of reduced QT caps to be delayed until the June meeting,” Deutsche Bank economists said. “While officials appear broadly agreed on the parameters around this tweak, we suspect they will want to avoid any dovish misinterpretation from slowing QT that could inadvertently ease financial conditions.”

The June meeting will bring the next round of Fed forecasts on interest rates and key economic variables, and “pairing the announcement with a more hawkish signal from the dot plot at the June meeting might be preferred” to avoid any mixed policy messages, the bank said.

Analysts at LH Meyer also favor a June announcement on the balance sheet, noting “the FOMC could decide on the broad contours ('Principles and Plans') and publish them after the May meeting to give the markets some confirmation of what the process would look like, without prejudging when it would then take that step.”

(Reporting by Michael S. Derby; Editing by Dan Burns and Andrea Ricci)