The Federal Reserve Open Market Committee (FOMC) discussed how it might begin shrinking its balance sheet through asset sales during its April meeting, the minutes reveal. In the statement it released at that time, there was no mention of how or when the Fed would sell assets, but we now know that the topic was discussed at length. It looks like sales won't begin anytime soon, and they will be very gradual.
During the financial crisis, the Fed swelled its balance sheet to accommodate asset purchases for a variety of programs meant to increase credit and liquidity in the market. Here's a chart from the Wall Street Journal that shows the change:
As you can see, its balance sheet nearly tripled in size. Once it gets rid of all of the assets it purchased backed by mortgages, the agencies, consumer credit, etc., however, its balance sheet's size will be pretty close to what it was before the intervention.
So when will the sales begin? The minutes say:
A majority preferred beginning asset sales some time after the first increase in the Federal Open Market Committee's (FOMC) target for short-term interest rates. Such an approach would postpone any asset sales until the economic recovery was well established and would maintain short-term interest rates as the Committee's key monetary policy tool. Other participants favored a strategy in which the Committee would soon announce a general schedule for future asset sales, with a date for the initiation of sales that would not necessarily be linked to the increase in the Committee's interest rate target. A few preferred to begin sales relatively soon.
It doesn't look like asset sales will begin soon. In fact, the majority doesn't want to sell anything until the Fed begins raising rates. And as we know, it intends to keep rates at approximately zero for "an extended period."
How might those sales occur? The minutes explain that too:
Most preferred that the agency debt and MBS held in the portfolio be sold at a gradual pace that would complete the sales about five years after they began. One possibility would be for the pace to be relatively slow initially but to increase over time, allowing markets to adjust gradually. A couple of participants thought faster sales, conducted over about three years, would be appropriate and felt that such a pace would not put undue strain on financial markets. In their view, a relatively brisk pace of sales would reduce the chance that the elevated size of the Federal Reserve's balance sheet and the associated high level of reserve balances could raise inflation expectations and inflation beyond levels consistent with price stability or could generate excessive growth of credit when the economy and banking system recover more fully.
There's a difficult task here. The Fed must sell assets quickly enough to prevent inflation, but slowly enough that it doesn't shock the market. It doesn't want to crowd out the new issue markets by selling too much agency debt and mortgage-backed securities. In a perfect world, inflation won't be a threat, and the Fed can conduct sales gradually. But by the time it begins selling these assets, once the economy is close to full strength, inflation might become more of a real concern.
On that note, the minutes also provided a little more detail on maverick committee member Kansas City Fed President Thomas Hoenig's usual dissent. This time, they said what he was specifically calling for:
Mr. Hoenig believed that the target for the federal funds rate should be increased toward 1 percent this summer, and that the Committee could then pause to further assess the economic outlook.
Of course, Hoenig is the only one advocating raising rates in the near-term. That's good, because if the Fed raised rates this summer, the market would probably have a heart attack. Considering that inflation is not a threat in the short-term, but unemployment remains near 10%, it's not very likely other committee members will adopt his view by the June meeting.
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