Between 2009 and 2014, the Federal Reserve purchased about $4 trillion of U.S. Treasuries and mortgage-backed securities (MBS). These purchases increased the total value of assets the Fed holds, commonly described as the size of its balance sheet.
As the U.S. Treasury pays off principal on bonds and notes, and mortgages are repaid, the Federal Open Market Committee (FOMC), the Fed's chief policymaking body, has maintained a policy of reinvesting these proceeds into new purchases of similar securities.
When the FOMC begins scaling back the Fed's balance sheet, it is expected to do it by slowing the pace at which the central bank reinvests in Treasuries and MBS, as described in the June 2017 addendum to the FOMC's Policy Normalization Principles and Plans. But just how do the large-scale asset purchases expand the Fed's balance sheet? And how would cutting back on reinvestments in those assets shrink the balance sheet?
The New York Fed's Liberty Street Economics blog explains the process in a pair of posts from July 10 and July 11.
On the most basic level, the Fed's balance sheet will shrink as the central bank begins to curtail its reinvestments in Treasury bills and MBS. When the securities mature and the principal is repaid to the Fed, that money essentially disappears, thus shrinking the Fed's balance sheet.
If the Treasury issues new securities as old ones mature and the Fed does not buy new securities, then someone else must do so. The July 10 Liberty Street Economics post describes how two transactions happen simultaneously:
- [T]he Treasury repays the Fed for the maturing securities, which reduces the [Treasury General Account's] balances and the Treasury securities held by the Fed by the same amount.
- Banks purchase the new securities issued by the Treasury. This step results in a transfer of balances from the banking sector to the Treasury, offset by a transfer of securities to the banking sector.
At the end of this process, the size of Fed's balance sheet has decreased—it no longer holds the security nor the reserves held by banks—while the Treasury's balance sheet is unchanged.
Read the Liberty Street Economics posts for a more detailed explanation of reducing the Fed's balance sheet.
Charles Davidson
Staff writer for Economy Matters