The Fed will soon embark in an uncharted water of Quantitative Tightening (QT). In the aftermath of 2008 global credit crisis, the world central banks went into the biggest experiment in the monetary policy called Quantitative Easing (QE). Central banks printed money and bought the government bonds as the primary way for monetary expansion. The combined balance sheets of the three world central banks below exploded in size to about $13 trillion:

In the U.S., the Fed went into large-scale purchases from 2008 – 2013. They tapered the purchases gradually to zero by 2014. As a consequence, the Fed now holds US $1.8 trillion of mortgage-backed securities (MBS) and US $2.5 trillion of US Treasury Bonds. The Fed has been reluctant to reduce the balance sheet, fearing that mortgage rates and other long-term borrowing costs can spike and hurt fragile US economy.

However, at its meeting last March 14-15, the Fed’s Monetary Policy Committee (FOMC) agreed it should start normalizing its $4.5 trillion balance sheet later this year. Another name for this “balance sheet normalization” is “Quantitative Tightening”. The Fed’s current practice is to buy new bonds when the old bonds mature. When the Fed starts the normalization, it will taper the reinvestment of principal. In other words, it will let the old bonds mature and not reinvest to buy new ones. This way the balance sheet shrinks as the Fed receives cash from maturing bonds and not reinvest it. The Fed can also decide to reduce the size of the balance sheet more rapidly by selling its securities holding. However, the passive and predictable option of not reinvesting is more likely.

The chart below projects Fed balance sheet if the Fed stops reinvesting principal from January 2018. By doing so, Fed’s balance sheet should be halved by the end of 2022.

The Fed wants to get back to normal monetary policy by raising short-term interest rate and shrinking the balance sheet. The interest rate is expected to go back to 2.5% by late 2018 (currently at 1%) while balance sheet is expected to shrink to $2 trillion by 2022. At Fed’s meeting on Wednesday this week, the Fed could announce the blueprint on how to do it.