Can the Fed Unwind Without Unnerving Markets?

The U.S. Federal Reserve has fired the starting gun. On Sept. 20, the central bank announced it will begin winding down its balance sheet beginning in October. Thus ends a decade of policy-making experimentation, in which the Fed purchased vast quantities of government bonds and mortgage-backed securities to help pull the U.S. economy from the brink of disaster. That rescue, known as quantitative easing, was designed to promote economic growth by keeping long-term interest rates low, but it also bloated the Fed’s balance sheet to an unheard-of $4.5 trillion. The Fed stopped its buying spree in 2014, but purposely refrained from shrinking its balance sheet until it was sure the economy was good and ready. To Fed Chair Janet Yellen and the rest of the Federal Open Market Committee, that moment has arrived.

The Fed’s balance sheet is equivalent to about a quarter of U.S. gross domestic product. By holding down yields on Treasury securities and mortgage-backed debt, the Fed made it cheaper for the U.S. government to finance its budget deficits and for home buyers to take out a loan. It reduced costs for companies in China and other emerging markets that borrow in dollars. It also had important implications for financial markets. The Fed’s purchases made U.S. Treasury securities more expensive, thus encouraging investors to buy stocks instead. This way, the Fed has helped fuel the huge run-up in equity prices since 2009.