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Shrinking balance sheet? What is its impact on financial markets?


On May 4, 2022, the Fed issued a statement that it will shrink its balance sheet starting in June, and it is estimated that it will shrink its balance sheet by about US$3 trillion in the next three years!!
The news came out and hit the stock market immediately!
What exactly does “shrink the balance sheet” mean? Why is the market so concerned?

What is “shrink the balance sheet.”

Shrinking the balance sheet refers to shrinking the Fed’s balance sheet.
In the Federal Reserve’s balance sheet, liabilities include excess reserves of commercial banks and currency in circulation, while assets are government bonds, gold, and various bonds. The number of liabilities affects the total amount of currency in circulation, while shrinking the balance sheet will reduce both assets and liabilities, so the amount of currency in circulation will decrease.

When Federal Reserve “shrinks the balance sheet,” it means reducing the Fed’s balance sheet. In short, it means slowly withdrawing the printed money. This is the central bank’s tightening monetary policy. The purpose is to adjust the overheated economy or curb inflation.

The QT we commonly hear is the abbreviation of “Quantitative tightening,” which is the practice of shrinking the balance sheet and is the complete opposite of quantitative easing (QE ).

What is the relationship between shrinking the balance sheet and raising interest rates?

A rising interest rate is often accompanied by a shrinking balance sheet. Both of them belong to the tightening monetary policy.
However, shrinking the balance sheet and raising interest rates are two different things, and they will not definitely happen simultaneously. Which policy will be implemented depends on the current economic environment. But usually, when the monetary tightening policy is adopted, the two usually work in parallel.
When the central bank raises interest rates, the interest rates on people’s deposits and loans will also increase. Therefore, people and companies will be more willing to store their money in banks, reduce investment and consumption, and demand higher investment returns. As a result, there will be less hot money in the market.
In this way, the policy can achieve the same effect as shrinking the balance sheet to regulate the overheating of the economy or curb inflation .
The policy of raising interest rates is relatively aggressive, while the shrinking the balance sheets is relatively moderate
Although both are tightening policies, the impact of raising interest rates is usually more significant than that of shrinking the balance sheet, and it is also a more radical policy.
Conversely, although shrinking the balance sheet is also a tightening policy, it will be more moderate than raising interest rates.

What is the difference between shrinking balance sheets and tapering bond purchases?

Another operation similar to shrinking the balance sheet is reducing tapering bond purchases (or reducing bond purchases).
Shrinking the balance sheet: stop buying new bonds or even sell bond assets so that the liabilities on the central bank’s balance sheet can be reduced.
Reduce bond purchases: Continue to purchase new bonds, but reduce the number of purchases. The central bank’s balance sheet will continue to expand, but the expansion speed will slow down.
Reducing bond purchases sounds similar to shrinking the balance sheet, which means reducing the amount of newly purchased bonds.
However, the reduction in bond purchases refers to purchasing fewer bonds during the expansion stage of quantitative easing. For example, the original monthly purchase of 10 billion new bonds was reduced to 5 billion. However, the Federal Reserve’s balance sheet is still expanding over time despite the speed of expansion slowing down.
Shrinking of the balance sheet, on the other hand, is to stop buying new bonds so that the Fed’s balance sheet will decrease over time.
Compared with reducing the balance sheet, reducing bond purchases is a milder tightening measure than shrinking the balance sheet. When the bond purchases are reduced, the market is still in a state of loose balance sheet expansion.

The impact of shrinking the balance sheet on the stock market

Shrinking the balance sheet increases bond yields, while the Federal Reserve also raises interest rates to curb hot money. The capital market will become more sensitive when interest rates rise because the business loan cost will increase. Therefore, businesses will be more cautious and dare not to borrow money at will to expand, thereby curbing the overheated economy; and for businesses with high growth prospects but no actual profits at present, investing in such companies is considered riskier. When investors are risk-averse, there is often a pullback in the market.

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