The Federal Reserve made headlines at its May meeting when it raised interest rates by the single biggest hike since 2000, but another lesser-known decision — albeit a substantially more complex one — could have an even greater influence over how much you pay to borrow money.
The Fed said in May that it’s going to soon start shrinking its massive near-$9 trillion bond portfolio. The decision is almost seven months in the making, but officials are going to ease their way into it. Starting June 1, they’ll let $47.5 billion worth of assets roll off their books, more formally known as the balance sheet. Then, they’ll gradually increase that number over a three-month period until it hits $95 billion by September.
Why does the Fed’s shrinking balance sheet matter?
It’s the antithesis to the Fed’s massive bond-buying campaign during the coronavirus pandemic. Across three different programs, the Fed amassed almost $4.6 trillion worth of bonds, including Treasurys and mortgage-backed securities. Those moves helped push the interest rates that the Fed normally doesn’t directly control to rock-bottom levels — including on things like mortgages and student loans — by bolstering liquidity and keeping the system awash with credit.
But what goes down must come back up. Shrinking the balance sheet could be just another lever that pushes interest rates higher, along with what’s likely to be the fastest rate-hiking cycle in decades. That’s because the endeavor effectively reduces the money supply and the availability of credit in the financial system. It’s a sacrifice the Fed is willing to make to help cool the rapid inflation that’s spent six straight months at levels not seen since the 1980s. The process is often dubbed quantitative tightening.
“It’s also another way in which the Fed is pressing on the brakes in an effort to slow the economy and reduce inflation,” says Greg McBride, CFA, Bankrate chief financial analyst. “Over time, this is going to be more impactful…
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