The Federal Reserve (the Fed) is gearing up to reduce the rate at which money exits the economy. This phenomenon is known as ‘Balance Sheet Runoff’ and is considered good for the current U.S. markets. Federal Reserve Chair Jerome Powell communicated this direction to reporters during a press briefing on Wednesday, stating that the Fed would “slow the pace of asset runoff fairly soon.”
Let’s take a look at why balance sheet runoff may serve the current U.S. market well.
Understanding Balance Sheet Runoff
Each month since the fall of 2022, The Federal Reserve has been decreasing the amount of money in the U.S. economy through a process known as balance sheet runoff. Balance sheet runoff, also referred to as quantitative tightening (QT), involves the Federal Reserve gradually reducing the assets on its balance sheet by allowing bonds that it had previously purchased to mature without reinvesting the proceeds into new securities. This reduces the amount of money available in the economy, essentially draining liquidity as these assets mature and are not replaced. QT is a reversal of Quantitative Easing (QE), which initially aimed to inject more money into the economy to reduce borrowing costs.
To provide context for the implementation of QT, inflation accelerated in mid-2021 partly due to the effects of QE. In response, the Federal Reserve raised overnight Federal Funds rates and introduced QT measures to address the growing prices.
Furthermore, Chair Powell addressed ongoing efforts to manage inflation levels in a recent meeting, highlighting that they had not yet reached the Fed’s desired targets. In the same meeting, Chair Powell remarked that inflation has not yet returned to levels considered comfortable by the Fed but noted progress in this regard.
Slowing Balance Sheet Runoff Benefits Markets
A slower pace of quantitative tightening (QT) than what the markets had factored into prices is beneficial for both stocks and bonds. It implies that more money will remain in the economy to foster growth and fewer bonds than anticipated will be available for purchase. This reduced supply will enable sellers to negotiate lower rates, viewed positively across all markets.
While the Federal Reserve has yet to act on reducing the pace of balance sheet runoff, the recent all-time highs witnessed by major indexes suggest that the expectation is already influencing market sentiments. Regarding the Fed’s schedule, Chair Powell explained in a press conference that the phrase “fairly soon” means just that, intended to convey a prompt timeline.
