September 20, 2017 / 9:55 PM / 3 months ago

Breakingviews - Fed balance-sheet runoff could rock fiscal boat

WASHINGTON (Reuters Breakingviews) - The Federal Reserve is sailing into uncharted waters. The U.S. central bank will start shrinking its $4.5 trillion balance sheet next month. The timing is risky, with lawmakers set to spar again over government funding and the debt ceiling. The Fed’s portfolio downsizing will also cut the nearly $92 billion it sent to Treasury last year, adding to budget pressures.

As expected, the Fed on Wednesday set a start date for its effort to reverse the balance-sheet expansion it undertook in response to the 2008 financial crisis, following a step-by-step plan unveiled in June. It will gradually stop reinvesting the proceeds from repayments of Treasury bonds and mortgage-backed securities, allowing up to $30 billion in assets to roll off the balance sheet in the first three months of the process. Once ramped up, the portfolio could shrink by $150 billion a quarter.

Though the Fed doesn’t seem to anticipate market disruption, one economist speaking at the Shadow Open Market Committee fall meeting on Friday argued that balance-sheet reduction is, in its ultimate effect, equivalent to raising interest rates.

Moreover, the unprecedented shift will coincide with another fiscal showdown in Congress. Earlier this month, lawmakers approved a three-month delay in setting government funding for 2018 and raising the $20 trillion federal-debt ceiling. The new deadline is Dec. 8. If there is no deal by then, the government could partially shut down and the clock would start counting down to the possibility of a government default.

In the meantime, the U.S. deficit continues to grow. It’s estimated to hit $693 billion this year, an 18 percent jump from 2016, according to the Congressional Budget Office. The Fed’s balance sheet reduction could worsen that. Its remittances to the Treasury have topped $90 billion a year for the last several years, but a smaller portfolio will mean less interest income. Before the financial crisis, the Fed’s balance sheet was under $1 trillion and in 2008 the central bank sent only about $32 billion to the Treasury.

Congress already had to unexpectedly increase 2017 spending by $15 billion because of Hurricane Harvey and more will be needed for that recovery effort and reconstruction following Hurricane Irma. However clearly the Fed has telegraphed its policy moves, they could still rock the fiscal boat.

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