The Federal Reserve made headlines at its May meeting when it hiked interest rates by the biggest hike since 2000, but another lesser-known – though far more complex – decision could have an influence. even greater on the amount you pay to borrow money. .

The Fed said in May that it would soon begin trimming its massive bond portfolio by nearly $9 trillion. The decision has been in the works for nearly seven months, but officials will work their way through it. Starting June 1, they will let $47.5 billion in assets off their books, more formally known as the balance sheet. Then they will gradually increase that number over a three-month period until it hits $95 billion by September.

Why is the reduction in the Fed’s balance sheet important?

It’s the antithesis of the Fed’s massive bond-buying campaign during the coronavirus pandemic. Through three different programs, the Fed amassed nearly $4.6 trillion in bonds, including Treasuries and mortgage-backed securities. These measures have helped push interest rates that the Fed does not normally directly control to low levels – including on things like mortgages and student loans – by bolstering liquidity and keeping the system awash with credit. .

But what goes down must go up. Shrinking the balance sheet could be just another lever pushing interest rates higher, as well as what will likely be the fastest rate hike cycle in decades. This is because stress effectively reduces the money supply and the availability of credit in the financial system. It’s a sacrifice the Fed is willing to make to help calm rapid inflation that has spent six straight months at levels not seen since the 1980s. The process is often referred to as quantitative tightening.

“It’s also another way the Fed is stepping on the brakes in an effort to slow the economy and reduce inflation,” said Greg McBride, CFA, chief financial analyst at Bankrate. “Over time, this will have more impact than raising short-term rates.”

This decision would have major implications for the cost to consumers of financing major life events, from buying a house or a car to college.

If things go according to plan, the Fed will have withdrawn about $570 billion from the financial system by the end of 2022 and another $1.1 trillion by the end of 2023. Cut $1.5 trillion of the Fed’s portfolio is equivalent to raising interest rates. an additional 1 percentage point, according to estimates by Luis Alvarado, vice president and investment strategy analyst at Wells Fargo Investment Institute.

“We understand what the Fed did at the height of the pandemic in March 2020 when everyone was scared,” Alvarado says. Fed officials, however, don’t want to “have big balance sheets. They want to have parallel balance sheets based on economic growth.

How much will interest rates rise as the Fed shrinks its balance sheet?

But the big question mark is whether the officials will have enough room on the track to make it happen.

The Fed has only ventured down this path once before: when the economy was recovering from the Great Recession of 2007-2009. At the time, they managed to suck roughly $700 billion out of the system, or just 20% of what they bought, before the financial markets seized up and the economy risked plunging.

At the Fed’s current pace, the Fed’s balance sheet would reach its pre-pandemic size of $4.3 trillion four years from June 2022. But a lot can change in the economy by then – and a lot can also go badly enough for Fed officials to abort the mission.

“I don’t think the Fed can take too many trillions out of the system without something happening overnight,” McBride said. “If the economy weakens, eventually they will ease policy or the pace of quantitative tightening.”

The Fed’s inflation-fighting plan is unlike any other in recent history

The Fed’s latest foray into reducing the money supply was also very different from today’s experience, with another layer unclear how much of an impact consumers might feel. The Fed waited nearly two years to start selling bonds after raising interest rates for the first time after the December 2015 financial crisis. This time the Fed is waiting only three months.

Not only that, but officials had previously opted to gradually increase the number of bonds they would let out of their portfolio over a 12-month period, until it eventually hit $50 billion a month. Today, the Fed is moving four times faster and its monthly cap is almost twice as high.

Have the biggest rate increases already happened?

Lenders have also been raising their borrowing costs at a much more aggressive pace than the Fed — and long before officials even hit interest rates or their balance sheets.

The average rate for a 30-year fixed-rate mortgage in the week ending May 11 jumped to 5.46%, the highest point since August 2009, according to the National Survey. Bankrate. On the day of the December 2021 Fed meeting, that benchmark mortgage was 3.28%. A year ago, it was 3.19%.

The rise outpaced Fed hikes and the rise in the 10-year Treasury yield, with the key bond yield rising just 1.44 percentage points in total since the Fed’s December meeting.

That signals that the sub-5% mortgage rates that consumers enjoyed for more than a decade — plus an eight-week stretch in 2018 — are all but in the rearview mirror, according to McBride.

“When the biggest buyer in the market leaves the table, it creates a vacuum,” he says. “There must be investors to fill this void, otherwise prices could fall sharply and rates could rise significantly in order to attract enough investor demand.”

It’s too early to tell what exactly happens with interest rates from here, but some experts say the biggest jumps may have already happened.

“The mortgage market is the epicenter of this,” says Kristina Hooper, chief global market strategist at Invesco. “But quite often markets move ahead of expectations; much has already been assessed.

Alvarado sees the 10-year Treasury yield rising another 44 percentage points, peaking at 3.35% in the fourth quarter of 2022. Then he sees it gradually stabilizing throughout 2023 in a range of 2.5 to 2.75%.

This is exactly what happened in the last Fed tightening cycle. Technically speaking, the 10-year Treasury yield rose only 62 percentage points during the Fed’s entire last tightening cycle – starting with its first rate hike on December 16, 2015 and ending on the day where the Fed officially stopped reducing its balance sheet. September 30, 2019. The policy rate erased almost half of its gains over the period, falling to 1.68% on September 30 after peaking at 3.24% on November 8, 2018.

The swing highlights another key point about market interest rates: the 10-year Treasury rate could fall even if the Fed raises rates, especially if investors anticipate an economic slowdown or lower l ‘inflation.

“That’s what happens most of the time when the Fed tightens policy,” McBride says. “We’re heading for a point where those long-term yields are starting to come down at the same time that short-term rates are going to rise.”

Other Factors That May Affect Interest Rates

The impact on the consumer also depends on more technical reasons. When the Fed reduces its balance sheet, it does not sell these securities; instead, he simply lets those bonds roll to maturity without reinvesting his principal payments.

Still, some pundits have pointed out that the Fed may struggle to meet the quota it has set for mortgage-backed securities. If so, they might have to sell those assets for the first time in Fed history, which would have even bigger implications for mortgage rates. The massive stockpile of these Fed securities – $2.7 trillion – has undoubtedly kept the cost of financing a home from rising even further.

Fed officials indicated in the minutes of the January and March Fed meetings that this strategy “may be appropriate at some point in the future”, so that the Fed can move towards a portfolio of longer-term bonds “composed primarily of Treasury securities”. Top Fed officials have also said the approach could be an even more aggressive relief plan if inflation remains high.

Selling assets also exposes the Fed to another risk it has so far been able to dodge: incurring a loss.

At the end of the line

Less money lying around in the financial system tightens financial conditions overall. This could cause companies to delay any new investment, including hiring. The worst case scenario is an increase in unemployment.

All of this goes to show that the contraction in the Fed’s balance sheet is a major factor to watch going forward – and also a reason to focus on building up your emergency fund.

Another group caught in the crossfire could be investors. The Fed’s plans to unwind its balance sheet contributed to the year’s volatile financial conditions, with the S&P 500 down more than 16% to start the year.

Keep a long view and turn a deaf ear: the Fed’s overarching goal is to get monetary policy on track to a more sustainable level that paves the way for a long and lasting expansion and removes pressures massive on financial market prices. system.

Still, the Fed’s balance sheet reduction is a major unknown, and only with hindsight will investors and consumers be able to judge its full impact.

“It’s the Wild West of monetary policy,” says Invesco’s Hooper. “We are in the country of experimental monetary policy. We just don’t know how it’s going to pan out. »

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