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The Financial Market Effects of Unwinding the Federal Reserve’s Balance Sheet

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  • Andrew Lee Smith
  • Victor J. Valcarcel

Abstract

For the second time in the brief 12-year period between 2008 and 2020, central banks have once again turned to asset purchase programs to combat a global economic downturn. While balance sheet expansions have become familiar, balance sheet normalization has proven more elusive. Nevertheless, an understanding of the consequences of unwinding asset purchases is necessary for well-informed decisions over the deployment of these unconventional policy tools. This paper provides a first analysis of the financial market effects of balance sheet normalization based on the U.S. experience between 2017 and 2019. We find evidence that balance sheet normalization tightens financial conditions. Importantly, we show these effects cannot be merely characterized as quantitative easing in reverse. In particular, we find that balance sheet normalization was associated with larger liquidity effects than were evident during various phases of balance sheet expansion.

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  • Andrew Lee Smith & Victor J. Valcarcel, 2021. "The Financial Market Effects of Unwinding the Federal Reserve’s Balance Sheet," Research Working Paper RWP 20-23, Federal Reserve Bank of Kansas City.
    • Handle: RePEc:fip:fedkrw:89535
    DOI: 10.18651/RWP2020-23
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    Cited by:

    1. Karlye Dilts Stedman & Chaitri Gulati, 2021. "When Normalizing Monetary Policy, the Order of Operations Matters," Economic Bulletin, Federal Reserve Bank of Kansas City, issue October 1, pages 1-4, October.
    2. Bonam, Dennis & Ciccarelli, Matteo & Gomes, Sandra & Aldama, Pierre & Bańkowski, Krzysztof & Buss, Ginters & da Costa, José Cardoso & Christoffel, Kai & Elfsbacka Schmöller, Michaela & Jacquinot, Pasc, 2024. "Challenges for monetary and fiscal policy interactions in the post-pandemic era," Occasional Paper Series 337, European Central Bank.
    3. Chen, Zhengyang & Valcarcel, Victor J., 2021. "Monetary transmission in money markets: The not-so-elusive missing piece of the puzzle," Journal of Economic Dynamics and Control, Elsevier, vol. 131(C).
    4. Axelsson, Birger & Song, Han-Suck, 2023. "The effect of quantitative easing and quantitative tightening on U.S. equity REIT returns," Working Paper Series 23/9, Royal Institute of Technology, Department of Real Estate and Construction Management & Banking and Finance, revised 14 Nov 2023.
    5. Laine, Olli-Matti & Pihlajamaa, Matias, 2023. "Asymmetric effects of conventional and unconventional monetary policy when rates are low," Bank of Finland Research Discussion Papers 3/2023, Bank of Finland.

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    More about this item

    Keywords

    Monetary Policy; Balance Sheet; Liquidity Effect; Structural VAR; Financial Conditions;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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