Since the beginning of the financial market meltdown in August of 2007 the U.S. Federal Reserve’s balance sheet has increased enormously. The total assets of the Fed increased from $869 billion on August 8, 2007 to $4.45 trillion as of February 13, 2017.

The Fed expanded its balance sheet during and after the financial crisis by purchasing large quantities of Treasuries and mortgage-backed securities. The composition change in the balance sheet was largely related to the Fed’s support of the mortgage granting institutions to contain the collapsing housing sector.

As the following two charts illustrate, the total assets at the Fed have been relatively constant at the current $4.4 trillion level since the end of the last quantitative easing phase (Q3).

Recently, after a decade of highly expansionary monetary policy, the Fed has begun to raise interest rates and a process of normalization is under way. The Fed’s clear intent is to gradually increase the federal funds rate up to more normal levels, since the slowly growing American economy is close to full employment and inflation seems to be trending close to the Fed’s 2% target.

The normalization process will involve further federal funds interest rate hikes and could, at some point, also involve a decision to gradually shrink the size of the Fed's balance sheet.

The reduction in the size of the balance sheet is a somewhat less discussed monetary tightening option, though there have been some comments from investors wondering if this approach is also on the table.

We tend to think that the Fed could accomplish its normalization objectives without shrinking the balance sheet.

But if the Fed wants to tighten monetary policy faster and more effectively, then shrinking the balance sheet is the way to go. That is, the Fed could raise interest rates faster and further out along the Treasury yield curve by shrinking the size of its balance sheet.

In other words, shrinking the balance sheet and shifting the composition of its assets back more heavily to Treasury securities offers a series of subtle options.

For example, imagine if the Fed does not want to raise the federal funds rate, but wants to target higher longer-term yields. This could be accomplished via balance sheet changes which would more heavily effect longer-term rates.

The sheer weight of the balance sheet helps to hold down longer term rates which is why the Fed undertook QE in the first instances. It is worth noting that $1.4 trillion of the $2.5 trillion in Treasuries have less than five years to mature. If the Fed allows these holdings to mature without re-investing the principal, the impact could be quite dramatic on the bond market. In particular the corporate side would be greatly affected since it is heavily weighted in the belly of the yield curve.

Source: Dr. Edward Yardini, Global Economic Briefing, March 21, 2017

Then there is the issue of the composition of debt held between Treasuries and Agency/MBS debt. Does the Fed replace MBS/Agency debt with Treasuries if it wants to hold the balance sheet constant? Or, does it do the opposite and expand MBS/Agency holdings?

Any relative reduction in Treasuries holdings has implications for the Federal budget and financing the deficit.  Similarly, any reduction in MBS holdings has implications for the interest rates affecting the housing market. Hence, the Fed is treading a fine line in developing an exit strategy.

In other words, there seems to be an abundance of subtle policy options associated with managing the size of the its balance sheet, and the Fed’s normalization process at this juncture is still not all that clear.