With the Fed widely expected to raise interest rates by a further 25 basis points at the end of its two day meeting on Wednesday, it might be tempting to think of it as a non-event. However, as we have been highlighting for at least the past year, it’s not just interest rates that matter, the size of the Fed’s balance sheet is also an important factor. Whether we get much clarity on this aspect from this meeting remains to be seen but it is something we will be watching closely; here’s why.
Quantitative easing is achieved by acquiring bonds whilst at the same time supplying the market with cash. This results in an increase in the Fed's balance sheet which ballooned from around USD 900bn in 2008 reaching a peak of around USD 4.5tn. The reversal of QE, quantitative tightening or QT sends that process into reverse but rather than the Fed selling bonds it instead has allowed some of the bonds to mature.
In the same way that QE is a decision to supply the market with a ‘quantity’ of liquidity rather than targeting a specific interest rate, QT is effectively the same decision only in reverse. So, whilst it is quite easy to provide more liquidity when rates are at zero, setting a target for Fed Funds whilst at the same time reducing the balance sheet is much more challenging. Consequently, one of the debates amongst Fed members is the management and size of the balance sheet itself.
In an interesting article back in February, Joseph Lavorgna, chief Americas economist at Natixis, writing for CNBC proposed that the Fed cap interest rates at 2% and then use the size of the balance sheet to manage the liquidity supplied to the market depending on economic conditions. This highlights the choice between setting an interest rate or altering the balance sheet.
Of course the reverse is also possible, fixing the balance sheet and then allowing rates to fluctuate. According to a Fed study, QE reduced long-term interest rates by 120 basis points and so if the balance sheet is not fully reversed then long term rates will remain structurally lower than before. So any hint that the eventual size of the Fed’s balance sheet might be much higher than some people had previously assumed, would be taken as a very positive signal for holders of Treasuries and investment grade bonds.