The interest rate committee of the Fed (the US Central Bank) decided on Wednesday, September 20, to start reducing the bloated balance sheet of the central bank from October. Through various rounds of quantitative easing (the large-scale purchase of government and corporate bonds), it has grown from $880 billion to almost $4.500 billion, an increase of more than 400%.
This reduction will proceed at a snail's pace. Since the end of QE policy, the Fed has been investing the amount that the bank receives as the owner of all those purchased government bonds in new government bonds. Starting in October, the bank will reduce those reinvestments by $10 billion. After each quarter, another $10 billion is added. When that ceiling reaches $50 billion, a pause will be introduced in the fall of 2018 and the bank will reassess whether a further reduction is necessary.
It is almost laughable to read here and there that the Fed will soon start rolling back the exceptional measures taken at the beginning of the crisis. A rollback would occur if the Fed were to sell all those purchased bonds in order to return the bank's balance sheet to its pre-crisis position. As I mentioned, the Fed's balance sheet at the time was about $880 billion.
Normal policy in 2050
What the bank will do is invest $10 billion less every month and increase that amount by $10 billion every quarter. This means that the principal amount of $4.500 billion not only remains unchanged, but even continues to increase. This is because the Fed's monthly revenues exceed the $10 billion reduction.
If the Fed then decides to continue this reduction in September 2018 and sells $10 billion every month, the bank's balance sheet would not return to 2050 levels until sometime after 2007. For long-term interest rates, this means that a new decline in monetary policy is unlikely. These interest rates would fall if, for example, economic growth were to decline unexpectedly.
Interest rates under upward pressure
That said, a rapid and rapid increase in long-term interest rates is also not expected. There is a good chance that they will come under upward pressure.
On the one hand, because the Fed will, albeit gradually, buy fewer corporate and government bonds and thus continue to push interest rates down, and on the other hand simply because economic growth is so high that it can be expected that interest rates will be pulled up along with it.
The biggest effects could well be seen in the EUR/USD rate. It fell after the Fed meeting and it would not be surprising if the price remains under downward pressure in the coming months. On the one hand, because it is now clear that the Fed is taking steps towards a less loose monetary policy and on the other hand, because it remains to be clear whether the ECB will do the same. If so, to what extent and whether the ECB will accelerate its own phasing out of QE policy.
Another reason why a further decline in EUR/USD in the coming months would not be surprising has to do with the Fed's interest rate policy in 2018 and in comparison to the ECB's interest rate policy. The prospects of the Fed's policy will be discussed in our interest rate video tomorrow.