Fed Chair Jay Powell said Wednesday that central bank officials discussed a strategy for how to slow the shrinking of the Fed’s balance sheet, a lesser-known policy tool it has been using to tighten financial conditions.
The Fed’s Federal Open Market Committee did not make a final decision while meeting in Washington, D.C., Powell added.
But he expects it will be appropriate to start that slowdown "fairly soon."
Over the last two years, the Fed has shed roughly $1.5 trillion in Treasury and mortgage bonds that it accumulated while trying to stimulate the economy during the early parts of the pandemic — letting the securities run off at a pace of roughly $95 billion every month.
The strategy is known as "quantitative tightening," or QT, and it is a key tool in the Fed's arsenal to cool financial conditions — along with hikes to the Fed's benchmark federal funds rate.
Allowing those bonds to mature acts to push up long-term interest rates as more bonds have to be snapped up by other investors.
In discussing a slowing of that runoff, policymakers hope to avoid the sort of messy upheaval in financial markets that happened the last time the Fed tried to wind down its balance sheet at the end of last decade.
"The decision to slow the pace of runoff does not mean our balance sheet will shrink, but allows us to approach that ultimate level more gradually," Powell said. "In particular, slowing the pace of runoff will help ensure a smooth transition, reducing the possibility of money markets experiencing stress."
The Fed tried QT once before, starting in 2017, when Janet Yellen was in charge of the central bank.
That shrinking of its portfolio drained bank reserves held at the central bank and led to some unexpected turbulence in 2019 after Powell had taken over.
It created a cash crunch that caused rates to jump on short-term "repo" loans banks make to each other. The upheaval forced the Fed to begin buying again, which calmed markets.
“We want to avoid any kind of that turbulence,” Powell said Wednesday.
To avoid such upheaval, Powell said the Fed will carefully monitor money market conditions and ask what that tells the central bank about the level of reserves in the banking system.
Right now, Powell said he would characterize the level of reserves as "ample" and the Fed is aiming for "abundant," which he said is a little less than ample.
The Fed's securities holdings topped out at $9 trillion in 2022 — the year it decided to pivot and act aggressively to tamp down rising inflation.
Since QT began roughly two years ago, the Fed’s balance sheet has shrunk to around $7.5 trillion.
Powell on Wednesday declined to say by how much the runoff could be slowed exactly, but he did say that the "longer-run goal" is to get to a point where the balance sheet is "mostly" Treasurys — as opposed to mortgage-backed securities.
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