Honey, I Shrunk the Balance Sheet!

(Projections of the Fed’s Securities Portfolio)

We present our baseline projection of the Fed’s portfolio of Treasury securities and agency MBS, based on information from the FOMC and our assumptions about future balance sheet policy. ▪ Our baseline assumption is that the FOMC will formally announce the start of runoff at its September  2017 meeting. The runoff will begin in the following month (October 2017).  

▪ We also assume that the FOMC will not sell MBS, instead preferring to wind the MBS portfolio down  purely through runoff.  

The balance sheet is assumed to shrink until it declines to a normalized level, which is determined mainly by liabilities such as currency and reserves. After that, the Fed will expand it in line with its trend growth.  ▪ Under our baseline scenario, we anticipate that the securities portfolio will shrink from $4¼ trillion to $3  

trillion by late 2020, after which it will expand to keep up with trend growth in liabilities through the acquisition of Treasury securities at auction.  

▪ The MBS portion of the balance sheet will continue to shrink naturally via runoff, although the Fed would still hold $1 trillion in late 2020. 

We also present an alternative scenario to illustrate the impact of sales of agency MBS. ▪ If the Fed decides to sell any assets, it would sell MBS rather than Treasuries because of its preference for returning to an all-Treasuries portfolio. Once the total portfolio size declines to its trend size, the Fed will likely opt to expand its portfolio along the trend line with purchases of Treasuries. ▪ The Treasury securities portfolio would be much larger under scenarios that include sales of agency MBS because, with MBS holdings declining faster, the Fed would have to buy Treasury securities at a faster clip just to keep the balance sheet growing at the trend. 

▪ A slightly later beginning to runoff would have little effect on the evolution of the balance sheet. 

The impact on the Treasury yield curve of the likely configuration of the Fed’s securities portfolio will depend on the Fed’s decisions about the maturity distribution of its eventual Treasury securities purchases and also  Treasury’s decisions about issuance.  

▪ We currently assume that all proceeds from maturing Treasuries will be reinvested on a pro-rata basis,  which is the current practice. The Fed’s reinvestments in Treasuries are driven mechanically by the tenor profile of new Treasury issues. 

▪ However, the Fed could actively shape the maturity distribution of its holdings. For example, it could alter the maturity distribution of purchases, as it did with earlier asset-purchase programs.  ▪ Treasury policy is also a source of uncertainty—not only how Treasury reacts to the Fed ending reinvestment purchases but also decisions not directly linked to Fed policy, such as the maturity profile of issuance or development of new Treasury securities. 

Ultimate Size of the Balance Sheet 

As we have written previously (The Size and Composition of a Normalized Fed Balance Sheet), the ultimate size of the balance sheet depends on the liabilities side of the balance sheet. Specifically, it depends on the choice of longer-run operating framework, and especially on the number of reserves the Fed sees as most appropriate under that framework. Because the balance sheet is well above the normalized size corresponding to any of the choices of the operating framework under consideration, we see this consideration first becoming relevant once the balance sheet declines to the level of the liabilities-implied trend size, after which the Fed will expand its balance sheet in line with the trend growth of its components.  

We believe that the Fed will want to remain in the current operating framework, meaning with a number of reserve balances sufficiently high that the funds rate would fall to close to zero without the support of tools like the interest rate paid on excess reserves (IOER). With the notable exception of Governor Brainard, FOMC  members have been hesitant to come out in support of a specific longer-run operating framework, but it’s clear that the current operating framework is broadly seen as an improvement. In the old operating framework of scarce reserves, the Fed intervened regularly in the Treasury market to adjust the supply of reserves as needed so that the fed funds rate traded near its target level. In this piece, we assume the Fed remains in the current system of elevated reserves. However, we note that there are risks to this assumption, particularly with Republicans in Congress expressing dissatisfaction with the current operating framework. 

Runoff Caps 

Following the June meeting, the FOMC published the “Addendum to the Policy Normalization Principles and  Plans,” which specified the following monthly runoff cap schedule: 

Months After Start of Runoff Cap on Treasuries Runoff ($billion per month)Cap on MBS and Agency Debt Runoff ($billion per month)
1-3 4
4-6 12 8
7-9 18 12
10-12 24 16
13 onwards (maximum caps) 30 20

Source: Federal Reserve. 

The caps are only binding if the amount of principal maturing in a month (for either MBS or Treasuries) exceeds the relevant runoff cap. If it does, the amount exceeding the runoff cap is reinvested.  

Our Baseline Scenario: Some Observations 

Our baseline assumption is that the FOMC will formally announce the start of runoff at its September 2017  meeting. The runoff will begin immediately in the following month (October 2017). We also assume that the  FOMC will not sell MBS, instead preferring to wind the MBS portfolio down purely through runoff.  

Under our baseline scenario, we anticipate that the securities portfolio will shrink from $4¼ trillion to $3  trillion by late 2020, after which the Fed will acquire Treasury securities to grow the balance sheet in line with the trend growth of its liabilities. The MBS portion of the balance sheet will continue to shrink naturally via 

runoff, although the Fed would still hold $1 trillion in late 2020. Our expectations are roughly consistent with the prevailing expectation on the FOMC. President Williams, whom we see as close to the consensus, recently  noted that “it should take about four years to get the balance sheet down to a reasonable size.” President  Dudley recently noted that “we’re probably going to see a balance sheet five years from now that’s probably  in the order of 2-1/2 to 3-1/2 trillion rather than the 4-1/2 trillion-dollar balance sheet.” 

Figure 1 

Fed Securities Portfolio Under Our Baseline Scenario 

Sources: MPA, Federal Reserve Board, Federal Reserve Bank of New York, Bloomberg. 

For Treasuries, the expected principal payment profile indicates that during the one-year period in which the runoff cap is rising, the cap will be binding almost every month. But once the runoff cap reaches its terminal level ($30 billion per month), the cap is binding only in certain months because of the lumpy Treasury securities maturity schedule. The chart below depicts the principal repayment profile for our baseline assumption—which is a runoff announcement at the September meeting. 

    Figure 2 

       Expected Principal Payment Profile for Treasuries  

Figure 3 

Expected Profile of Fed Reinvestment into Treasury Securities 

      Sources: MPA, Federal Reserve Bank of New York, Federal Reserve. 

For MBS, we project prepayments using a simple model based on our rates forecast and consensus PSA  prepayment assumptions. As the average remaining maturity of the MBS portfolio declines, we expect prepayments to decline. At the same time, the monthly runoff caps ramp up over one year to $20 billion per month. As a result, we expect MBS runoff caps to be binding only during the first year of balance sheet runoff. In other words, reinvestment into MBS will likely cease by late 2018. 

 Figure 4 

                   Expected Principal Payment Profile for MBS 

Figure 5 

Expected Profile of Fed Reinvestment into Agency MBS 

Sources: MPA, Bloomberg, Federal Reserve Board, Federal Reserve Bank of New York. 

Alternative Scenario: MBS Sales  

We present an additional scenario to illustrate the implications of MBS sales. If the Fed decides to sell any assets, it would sell MBS rather than Treasuries because of its preference for returning to an all-Treasuries portfolio. Participants have indicated that the FOMC prefers not to participate in the MBS market: MBS  purchases and holdings are not credit-neutral (they distort the supply of the securities in public hands) and the prospect of GSE reform means any additional participation in the MBS market is undesirable, especially from a political perspective. 

MBS Sales?
No Yes
September Announcement A (Baseline) B

A: Baseline Scenario: September Runoff Announcement, No MBS Sales 

Our baseline assumption is scenario “A”: At its September meeting, the FOMC will formally announce the start of runoff. For now, we also assume that the FOMC will not sell MBS, instead preferring to wind the  MBS portfolio down purely through runoff.  

B: September Runoff Announcement, MBS Sales 

Scenario “B” assumes MBS asset sales that begin in April 2019, six months after the monthly runoff cap reaches its terminal level. We assume asset sales, like the runoff caps, will ramp up over a period of one year—to roughly $20 billion per month.  

Implications of Alternative Scenarios: Total Size 

Under both scenarios, the securities portfolio shrinks for the next few years (as a result of MBS and Treasuries runoff). Once the securities portfolio falls to its normalized size, it then increases in line with the trend growth of its liabilities. The expansion is achieved via outright purchases of Treasury securities while the runoff of  MBS continues. 

The chart below depicts the expected size of the securities portfolio under the two scenarios.  

Figure 6 

          Size of the Fed Securities Portfolio Under Both Scenarios 

                       Sources: MPA, Federal Reserve Board, Federal Reserve Bank of New York, Bloomberg. 

How early the Fed would resume net outright Treasury purchases depends importantly on whether and how the Fed sells MBS. The difference in the size of the securities portfolio in the two scenarios, at its widest, is roughly $175 billion. 

Scenario Date the Fed Resumes Outright Purchases of Treasury Securities
A (Sep/No MBS Sales) December 2020
B (Sep/MBS Sales) June 2020

Implications of the Alternative Scenario on the Treasury Securities Portfolio 

The expected size of the Fed’s Treasury securities portfolio depends greatly on whether the Fed decides to sell MBS. The dashed line below presents the scenario in which the Fed sells MBS about six months after the runoff caps reach their terminal levels. We anticipate that the Treasury securities portfolio would be much larger under these scenarios as the sped-up reduction in MBS holdings would mean that the Fed would buy  Treasury securities at a faster clip just to keep the balance sheet growing at the trend. Compared with the baseline no-sales scenario, the portfolio of Treasury securities under the MBS-sales scenario is roughly $800 billion larger by late 2023, and the gap between the two paths stays wide for the foreseeable future. 

Figure 7 

     Size of the Fed’s Treasury Securities Portfolio Under Both Scenarios 

      Sources: MPA, Federal Reserve Board, Federal Reserve Bank of New York, Treasury. 

From a flow perspective, MBS sales would imply a much faster pace of Treasury securities purchases than in a no-sales scenario. During the period that the Fed is selling MBS outright, the Fed would have to acquire  Treasury securities at a pace of roughly $35 billion per month, which is comparable to the pace of outright purchases under QE3 or about half of the pace of QE2. But once the disposal of MBS is completed, the pace of net Treasury securities purchases falls to the amount that is needed to grow the balance sheet at trend  (around $10 billion per month). Conversely, if there are no MBS sales, then the pace of net Treasury securities purchases is fairly stable (at $20 billion per month), as the MBS portfolio shrinks only gradually. One implication is that sales of MBS would have a major impact on the pace of Treasury securities purchases.  MBS sales could also make communications regarding Treasury purchases more difficult. 

Figure 8 

           Monthly Pace of Outright Treasury Securities Purchases  

               Once Balance Sheet Resumes Expansion 

 Sources: MPA, Federal Reserve Board, Federal Reserve Bank of New York, Treasury. 

Characteristics of Treasury Securities Purchases: Risk Factors 

In accordance with the New York Fed’s current operating procedures, we currently assume that the total maturing proceeds will be reinvested on a pro-rata basis: across all newly issued Treasury notes, bonds, TIPS,  and FRNs in proportion to the amounts being issued on the maturity date. With such a policy, the Fed is essentially acting in a passive manner in terms of determining the maturity of its purchases, by taking the tenor profile of Treasury’s issuance as given. 

This assumption is subject to several risk factors. In terms of the Fed’s decision-making, the Fed could well opt to shift the maturity composition of its Treasury securities portfolio. One possible direction would be to rebalance the portfolio so that its profile mirrors that of the entire universe of outstanding notes and bonds.  The Fed’s portfolio of Treasury securities has a higher weighted-average maturity than the entire universe of  outstanding Treasury notes and bonds, so such a rebalancing would require a tilt in reinvestment purchases, 

outright purchases, or both towards the shorter end of the curve.1In addition, the Fed has been entirely absent from the Treasury bills market in recent years, so the difference between the Fed’s Treasury portfolio and the entire universe of Treasury notes, bonds, and bills is even greater. It seems likely that the Fed will resume outright purchases of bills once net purchases of Treasury securities resume. 

Treasury policy also presents risks. Treasury anticipates that it will increase borrowing to finance the funding  gap caused by the Fed’s redemptions “by increasing both Treasury bill and Treasury nominal coupon auction  sizes, beginning with bills and then coupons, as appropriate.” The Treasury is likely to wait until the timing of Fed reinvestment is clearer—the November refunding or perhaps even early 2018—before deciding how to adjust issuance. Discussions also continue on the potential issuance of ultralong debt. Recent reports suggest that Treasury is considering introducing 50-year full-coupon or zero-coupon bonds or re-introducing the 20- 

year full-coupon bond. All else equal, if the Fed follows its current policy of reinvesting simply in what Treasury issues, then its securities portfolio would likely have a longer maturity and duration, as would holdings outside the Fed. Another concern is how deficit forecasts might shift and how the amount of outstanding debt could vary as a result of fiscal reform, the prospects for which remain highly uncertain. 

We shall explore these aspects further in upcoming research. 

Implications of the Alternative Scenario on the MBS Portfolio 

As we noted above, the Fed’s runoff caps and consensus prepayment projections imply that reinvestment into MBS would likely cease in late 2018. The decision on MBS sales is irrelevant for the path of MBS  reinvestment purchases because the binding factors are the runoff caps and the slowing pace of prepayments.  The decline in MBS reinvestment purchases would reduce the share of MBS pool issuance purchased by the  Fed from roughly 20% to almost zero. 

1 The Fed’s Treasury portfolio has a weighted-average remaining maturity of about 8 years, whereas the figure corresponding to all outstanding Treasury notes and bonds is under 7 years.

Figure 9 

Expected Profile of Fed Reinvestment into Agency MBS 

Sources: MPA, Bloomberg, Federal Reserve Board, Federal Reserve Bank of New York. 

From a stock perspective, a similar story holds: the share of outstanding agency MBS held by the Fed would fall from above 20%. With MBS sales, the MBS portfolio effectively disappears by 2024. But without sales,  it would still be roughly $1 trillion in 2024. While the FOMC has expressed its desire to return to an all Treasuries portfolio, actively selling MBS might pose risks that do not outweigh the perceived benefit of exiting the MBS market altogether. Letting the MBS portfolio passively runoff in the background might present the most desirable outcome. 

Figure 10 

Size of the Fed’s Agency MBS Portfolio Under Both Scenarios

  Sources: MPA, Bloomberg, Federal Reserve Board, Federal Reserve Bank of New York. 

Appendix: The Current Role of the Fed in the MBS Market  

In terms of stock outstanding, the Fed currently holds about 25% of agency MBS.  

                      Figure 11 

        Share of Agency MBS Outstanding Held by Fed 

   Sources: MPA, Federal Reserve Bank of New York, SIFMA.  

In terms of flow, ever since the Fed ended QE3 in 2014, Fed reinvestments have absorbed about 20% of gross new MBS pool issuance. One of the objectives of the Fed’s runoff caps is to ease the transition from absorbing 20% of the gross flow to absorbing none of it.  

     Figure 12 

       Monthly Fed MBS Reinvestment Share of Monthly Agency MBS Pool Issuance  

     Sources: MPA, Federal Reserve Bank of New York, Bloomberg. 

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