I’ve got shrinkage on the mind again. Maybe I’ve spent too much time in cold water this summer or maybe it’s just me getting old? I don’t know, but I do know that it’s becoming an increasingly important discussion as the Fed discusses its future policy options. I’ve talked about how the Fed will unwind its balance sheet in the past and how this isn’t a big deal. I was one of a handful of people at the time of QE’s initiation explaining that this policy was not nearly as important as many expected and that it would not cause hyperinflation, high growth and in fact might cause rates to decline. This was not just a contrarian view, but it was a very accurate contrarian view. So I think I’ve earned some credibility assessing these things over the years, but shrinkage can make a man feel insecure even when he’s confronted with things that he understands well. So let’s explore this a bit more.

The contraction of the Fed’s balance sheet works in the exact reverse manner that the expansion works. Reserve additions expand the balance sheet by buying assets and reserve deletions expand the balance sheet when assets are sold or mature. It’s worth noting that the contraction will very likely occur naturally via the maturation of existing bonds. This means that the bonds will mature and simply poof, disappear, from their balance sheet (see here for a more thorough explanation).

Okay, but how will all of this actually play out? Let’s put this in perspective because there will no doubt be a mountain of articles written about this in the coming years if it transpires. And much like I downplayed the impact of the Fed’s expansion of the balance sheet I am afraid I have to throw cold water on the shrinkage as well.¹

If we look at the existing securities and their maturities we can construct a general idea of the roll-off shrinkage that will occur over the next 10 years. Here’s the general perspective: