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Fed getting new rules of road ready for balance sheet unwind

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Federal Reserve officials surprised some onlookers by unveiling a rough plan for balance sheet runoff in the minutes for their May meeting.

[WASHINGTON] Federal Reserve officials surprised some onlookers by unveiling a rough plan for balance sheet runoff in the minutes for their May meeting. They were so on top of things, in fact, that many economists think more formal guidelines could come as early as this week.

"It could be June, it could be July - I certainly would not expect it to be any later than July," said Lou Crandall, chief economist at Wrightson ICAP LLC. "The process is moving very quickly." To avoid unsettling financial markets, the Fed wants to clearly communicate its unwind strategy well in advance, and the next step in that process is releasing a fresh version of its "Policy Normalization Principles."

Minutes of the Fed's May meeting both foreshadowed an update to the principles and provided details on how the unwinding might proceed by describing a staff plan to slow the reinvestment of maturing securities via gradually rising caps.

Officials will continue their discussion about how and when to start shrinking their US$4.5 trillion balance sheet during a meeting on Tuesday and Wednesday in Washington at which they are also widely expected to raise rates.

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If the central bank releases up-to-date guidelines this week, it's unlikely to include much colour beyond what the minutes have already laid out. Even so, such a step could serve as a signal that the Fed's planning process is making progress, suggesting the central bank could be ready to release details on caps and unwind timing before much longer.

"They're a lot closer to pulling the trigger on this than people think," said Stephen Stanley, chief economist at Amherst Pierpont Securities LLC in New York. "Changing the principles document in June would be one way to signal that, if they were so inclined." There's little consensus on exactly where the caps will be set. Michael Feroli, chief US economist at JPMorgan Chase & Co, has said the Fed will start with US$8 billion in Treasuries and US$4 billion in mortgage-backed securities before ultimately raising them to US$32 billion and US$16 billion. Steven Friedman, senior economist at BNP Paribas Asset Management, expects the first cap to be set at US$10 billion for Treasuries and US$5 billion for MBS, going up eventually to US$40 billion and US$20 billion.

In its May meeting minutes, the Fed said "policy makers agreed that the Committee's Policy Normalization Principles and Plans should be augmented soon to provide additional details about the operational plan to reduce the Federal Reserve's securities holdings over time." The question now is just what "soon" means. Mr Stanley thinks Fed officials will probably wait until the July meeting to make any change, partly because the Fed might want to keep the focus on its June rate hike, if it makes one. Fed officials have stressed that the federal funds rate is their primary monetary policy tool and they want the balance sheet to shrink in the background.

It's also possible that the Fed could release the updated document with the minutes that are scheduled for July 5 release.

"The Committee has recently dealt with the exit principles in minutes rather than as separate stand-alone announcements on the days of FOMC meetings and this approach has served it well, in particular by lowering the degree of drama around the balance sheet," Krishna Guha, vice chairman at Evercore ISI in Washington, wrote in a note to clients.

That said, there are instances where the principles have been updated at a press conference, including in June 2013, when then-Chair Ben Bernanke detailed that most committee members had come to believe that the Fed would not sell agency mortgage-backed securities outright during the process of normalising monetary policy.

Mr Crandall said he expects this update to the principles to come with a Fed decision so that Chair Janet Yellen can discuss them at her post-meeting press conference. If the change comes at a non-press conference meeting like July, he thinks a press call can be arranged as an explainer.

"In the past, the principles were over the horizon - now they're very near-term," he said.

If the Fed does update the guidelines, the changes could follow Governor Jerome Powell's outline of the balance sheet plan from earlier this month. Powell emphasised that the balance sheet will shrink passively to a size that "should be no larger than it needs to be to allow the committee to conduct monetary policy under its chosen framework." "I suspect that it is too early to give the specific caps - the actual numbers," Mr Guha said, explaining that the Fed strives to keep its options open, and will want to retain the choice to trade off between an earlier start and a lower initial set of caps or a slower ramp-up.

"The approach of drip-feeding the info into the market, little bit by little bit, is actually working out very well. It has contributed to the very calm market reaction."

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