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Ben Emons

How the Fed Could Unwind Its Balance Sheet

The reduction must be gradual and natural, and there must be a communication plan.
A woman with a plan.

A woman with a plan.

Photographer: Win McNamee/Getty Images

In her testimony before the Senate Banking Committee, Federal Reserve Chair Janet Yellen explained a strategy for unwinding the central bank’s balance sheet. Three factors could determine how this could unfold. The reduction must be gradual, it must be natural and there must be a communication plan. That means investors could encounter three effects: the stock-flow effect, the risk effect and the communication effect.

Fed research in 2012 estimated that for every $300 billion in Treasury bond purchases, yields declined by 30 basis points due to the “stock effect,” which happens because the reduction of available stock of Treasury debt to the public is likely to drive up the price and lower the yield of Treasury bonds. The “flow effect” was estimated by Fed research to be worth 3.5 basis points per Treasury auction. However, this effect depends however entirely on demand at the time of the auction.