Fed Hike Aftermath Series: Balance sheet reduction likely to be tabled this year

While the Federal Reserve policymakers have forecasted three rate hikes this year in the December meeting and discussed on that in their individual speeches, a little or no attention has been paid to the $4 trillion balance sheet. Both the financial market participants and the policymakers have ignored the implications of that.

We at FxWirePro expect the issue to come under the scanner of the policymakers pretty soon and a decision could be made this year. As of now, Fed’ stance remains that it could consider reducing the pile once the policy normalization is well underway. ‘Well underway’ is a vague term but we suspect that it at least means a rate above 1 percent, half of the Fed’s 2 percent inflation target. Currently, the Federal funds rate is in the range of 0.5 and 0.75 percent. We expect the Fed to arrive at some decision with regard to the balance sheet after two more hikes. Unless the inflation overshoots the target quite rapidly, the Federal Reserve is likely to adopt a no-reinvestment or lower-reinvestment way to reduce the balance sheet rather than direct selling back.

We forecast that instead of three rate hikes, Fed would deliver two hikes and a decision on the balance sheet reduction.