Why the Fed's shrinking balance sheet matters?

What the Federal Reserve buys is an asset, which is shown in itsbalance sheet. The Fed's assets consist primarily of U.S. Treasury notes, bonds and agency mortgage-backed securities (MBS).

- The balance sheet can be used to achieve the Fed's monetary policy.

- When the Fed purchase asset, it signals an easy monetary policy to support the economy.

- Conversely, the sale of Fed assets is a policy tightening approach that constrains financial conditions and asset values.

Fed's balance sheet has expanded to nearly $9 trillion as they aggressively bought bonds to shield the economy from Covid.

Inflation is one result of the easy money policy. Policymakers now turn to tight monetary policy to fight inflation.

A monetary tightening cycle usually follows three steps:

1. Taper - has finished by March 2022;

2. Interest rate hike - the Fed approved a 0.25 percentage point rate hike in March 2022 to bring the rate now into a range of 0.25%-0.5%. The target is around 2% by year's end;

3. Shrink balance sheet - According to FOMC minutes, the Fed would begin reducing the central bank balance sheet by $95 billion a month, likely beginning in May.

The record rally in US stocks and the boom in the housing market were built on low borrowing costs ushered in by the Fed's easy monetary policy.

Starting from early March, the higher interest rates anticipation sent mortgage rates soaring and stocks plummeting.

A smaller Fed balance sheet could accelerate those trends.

The supply of Treasuries available to investors will increase after the Fed shrinks its balance sheet, and drives US government bond yields to rise.

The increased supply could also have an impact on liquidity in the Treasury market, which has deteriorated to the worst level since the start of the pandemic.

After the 2008 financial crisis, the Fed waited until 2015 to raise rates and then a further two years to shrink its balance sheet, which was slower than this time it attempted to reduce its holdings.

According to FOMC minutes, we now only have information on time (beginning in May) and the upper limit ($95 billion a month).