The Extent and Consequences of Federal Reserve Balance Sheet Shrinkage

This paper discusses the process of balance sheet shrinkage that the Federal Reserve is currently undertaking. I argue that the overall balance sheet is unlikely to shrink by much and that it will remain a much larger share of nominal GDP than it was before the COVID-19 pandemic. I examine the effects of balance sheet shrinkage on asset prices, taking the perspective that these effects are mostly likely to be narrow, that is, specific to the price of the asset that the market has to absorb rather than spilling over to fixed income prices more generally. I argue that the effects of reducing the Fed's holdings of Treasuries can be thought of as equivalent to the Treasury increasing the amount and maturity of its issuance. I estimate that this will have very small effects on term premia and bond yields. The reduction of the Fed’s holdings of mortgage-backed securities might have larger effects on the yields of these securities, especially if the Fed starts selling these securities. Any substantive macroeconomic effect of balance sheet runoff is likely to operate through mortgage rates and the housing market.