The minutes of the May Federal Open Market Committee (FOMC) meeting, released Wednesday, provided (as expected) more information on the committee’s thinking about how and when to start the policy of normalizing the size of the Federal Reserve’s balance sheet. What was surprising was how much information was provided and how close the committee appears to be on agreeing on key elements of the plan.
As we discussed last month, the FOMC faces a choice on the pace and modality of balance sheet reduction. If it wants the process to be predictable it won’t be passive (as regards the mortgage-backed securities portfolio), and if it wants the process to be passive, it won’t be predictable. The May meeting minutes reveal that the Fed staff presented a cap and trade proposal for balance sheet reduction and that the committee broadly supported this approach, although a final decision will await a future meeting.
How would cap and trade work? This is our understanding of the proposed process, based on the brief synopsis in the minutes: Each month the FOMC would have a preannounced cap on the dollar amount of U.S. Treasuries and mortgage-backed securities (MBS) that would mature or roll off. Any maturing or MBS prepayments in excess of this cap would be reinvested: The Fed would “trade” by buying MBS in the secondary market, as it does now. The caps would rise over time and the path for the caps would be preannounced.
This is an elegant proposal that provides predictability to markets and optionality to the Fed. However, for the MBS portfolio, it is not a “passive,” set-it-and-forget-it plan. In months when a lot of MBS prepay, the Fed would reinvest every dollar above the cap, whatever it is. That said, taken literally, the staff cap and trade proposal is one-sided. If the MBS roll-off were less than the cap, the Fed would not sell MBS to get up to the cap.
In the May minutes, we also learned that there appears to be agreement on the committee to commence this balance sheet normalization process later this calendar year. What was left unresolved for now, and perhaps for some time, is the ultimate destination for the Fed’s balance sheet. There is a real possibility that normalization starts this year with the cap and trade program outlined above, which Yellen will then bequeath to her successor next year (if she is not reappointed). Then it will be up to her or him and the FOMC then in place to make the decision on how big a balance sheet the Fed wants to have.
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Richard Clarida is PIMCO’s global strategic advisor and a frequent contributor to the PIMCO Blog.