What is the Fed’s balance sheet plan? Yahoo U

Yahoo Finance's Brian Cheung explains what the Fed bought during the pandemic and how it plans to wind down its balance sheet on this week's Yahoo U.

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BRIAN CHEUNG: Yeah, Akiko, well, the Federal Reserve getting a lot of attention for the minutes that it released yesterday, regarding quantity tightening, $95 billion. Now, look, no one knows what any of that means. So let's kind of take a quick step back here and talk about what the Fed is trying to execute here. When the pandemic began, the Fed fired up the big money printer. And essentially, what they're trying to do now is bring out the money shredder. So this concerns the Federal Reserve's $9 trillion balance sheet.

Again, for two years, the Fed was trying to show markets just how serious it was about keeping borrowing costs low. So it went into the markets, bought up a bunch of stuff. But now with inflation super high, the Fed wants to start shrinking its holdings. Take that line down, which they hope will send the signal to markets that they're serious about taking the punchbowl way that the party's over.

But to understand how they'll do this, we need to know what they bought. So the purchases were mainly these types of securities. First off, US treasuries, so these would be government bonds, and then agency mortgage-backed securities. But think about these types of assets. They're not like stocks. They have maturities, which means that government bonds can be short. Think of one month or long-- think 30 years. And essentially, they just fade into the ether when they hit their end dates.

Now, during the pandemic, the Fed was simply replacing maturing bonds with new ones to keep the party going. But now, the Fed can let those bonds roll off the balance sheet once they reach maturity. And the meeting minutes that we got yesterday, which, again, covers a discussion that happened three weeks ago, shows the Fed laying out this strategy this time around.

And here are the details of exactly how they'll do that. There's going to be a monthly cap. First off, it's going to be $95 billion total a month. That means that they will gradually ramp up this process, which is also called quantitative tightening. And then they'll be able to predictably shrink the balance sheet to something smaller than $9 trillion.

But the point is, overall, the party's over. The Federal Reserve is raising interest rates. That's going to make it more expensive to borrow. And the money shredder, by undoing its bond purchases during the pandemic, is basically a massive advertising campaign to markets that we're really serious about this. So obviously, we'll have to see what the Fed actually does because no decision was made. The next meeting is in four weeks.