When even Maxine Waters asks the Fed Chairman what the expected level of the Fed's balance sheet is and when its runoff is projected to end, you know that it's serious.
While there was little new ground covered in the second day of Powell's second day of his semiannual Humphrey Hawkins Congressional testimony, the Fed Chair told lawmakers that he’ll soon announce a plan to stop shrinking the $4 trillion balance sheet which exploded from under $1 trillion before the financial crisis, to $4.5 trillion over the duration of QE1 through QE3, and which after shrinking by roughly half a trillion dollars, prompted a market quake and exasperated demands for the shrinkage to end.
"We’ve worked out, I think, the framework of a plan that we hope to be able to announce soon, that will light the way all the way to the end of balance sheet normalization," which will come sometime later this year, Powell said during today's testimony before the House Financial Services Committee, cited by Bloomberg. The next meeting of the policy-setting Federal Open Market Committee is March 19-20.
While the Fed’s bond portfolio amounted to about 6% of GDP before the crisis, the new data point unveiled by Powell on Wednesday is that the balance sheet will likely settle around 16 or 17% of GDP. It is currently about 19.5%,.so roughly 3 more GDP points of shrinkage and it will be over.
As the latest FOMC Minutes revealed, there is now near-unanimous support among FOMC members for halting the balance-sheet runoff, with a plan for halting the shrinkage expected by year end. Meanwhile, officials have agreed to continue operating with an “ample supply” of reserves, without spelling out what that meant for the size of Fed holdings. And confirming what most traders already knew, Powell said that "there is a lot of uncertainty around the actual level."
Repeating what he said previously, Powell said that the Fed "can’t go back to that very small balance sheet," because shrinking it means draining the reserves demanded by banks, which are required to hold high-quality and liquid assets; of course, in a normal world those assets would be bank loans and/or Treasuries, which however the Fed's perversion of bank incentives means that the "fortress" balance sheet of America's banks will rely in perpetuity on a little over $1 trillion in reserves. He added that the Fed has learned that it’s “good to be very careful with the balance sheet.”
Also repeating what the Fed has said before, namely that the Fed wants a balance sheet primarily comprised of Treasuries, Powell noted that Fed officials still haven’t decided whether to sell the central bank’s agency mortgage-backed securities holdings at some stage, adding that that choice is "closer to the back of the line," and that "we have to decide about the maturity composition, and things like that."
So while traders await more details on how and when the Fed's balance sheet runoff will end, Goldman commented after Powell's testimony that the bank now expects the FOMC to conclude its balance sheet runoff program at the end of the third quarter of 2019, and adding that according to today's testimony that announcement will come at the March meeting.
At the end of Q3, the Fed's assets are likely to total $3.7-$3.8tn, with bank reserves at $1.3-$1.4tn. From that point on, we expect reserves to decrease gradually further via the growth of nonreserve liabilities (i.e., currency outstanding) until they reach $1.2tn in 2020 H2. While an earlier end to runoff will temporarily lead to a larger balance sheet relative to a later end, it should not have a large effect on the long-run size, which is largely pinned down by equilibrium reserves and currency outstanding.
Specifically, at the end of Q3, the Fed's assets are likely to total $3.7-$3.8tn, with bank reserves at $1.3-$1.4tn, or well above the Fed's soft target of $1 trillion, a number which likely will never be reached due to concerns over more market tutbulence. From that point on, Goldman expect reserves to decrease gradually further via the growth of nonreserve liabilities (mostly in the form of currency outstanding) until they reach $1.2tn in 2020 H2. Goldman explains that while an earlier end to runoff - until recently consensus expected the balance sheet rolloff to end in mid-2020 - will temporarily lead to a larger balance sheet relative to a later end, "it should not have a large effect on the long-run size, which is largely pinned down by equilibrium reserves and currency outstanding."
Goldman also touches on the other open topic, namely how the Fed will approach the remaining holdings of MBS. According to Jan Hatzius, while Governor Quarles recently stated that the Fed would be open to “limited sales” of “residual holdings” after balance sheet normalization, it is unlikely that they will do so while they keep the size of the balance sheet flat. As a result, Goldman expects the Fed to maintain its current approach to MBS runoff as its base case in the near-term, even though eventual small sales of MBS of roughly $3-$5bn per month are quite possible. At the same time, Fed purchases of Treasury securities to replace MBS are likely to occur at the front end of the curve, and in the secondary market where purchases to replace other securities must occur. This dynamic is shown in the chart below, with Goldman's baseline scenario leading to a net increase in Treasury holdings after 2019Q3 while MBS holdings passively shrink, in order to keep the total size of the balance sheet flat.
Finally, a consequence of this is that as some other analysts have suggested, a deliberate shift toward shorter Treasury maturities is likely, i.e. a reverse Operation Twist. This would provide the Fed greater flexibility in a potential downturn to ease via maturity extension, in the same vein of Operation Twist.