Fed Tapers Balance Sheet Reduction Program

At their May 1 Federal Open Market Committee meeting, the Fed announced they would slow the pace at which they reduce the size of their balance sheet beginning in June.

The Fed bought trillions of dollars of government-backed bonds between 2020 and 2022 to support the recovery from the 2020 recession, and has been unwinding those purchases since mid-2022 by accepting repayment on a portion of the bonds as they mature.

Beginning in June, the Fed will lower the monthly cap on repayments of Treasuries they accept to $25 billion, from $60 billion previously. They will hold unchanged a $35 billion monthly cap on mortgage-backed security (MBS) repayments. This “taper” of the Fed’s balance sheet reduction (a.k.a Quantitative Tightening or QT) is a first step toward less restrictive monetary policy.

However, interest rate cuts are likely to come later in 2024 than expected when the year began, since inflation has surprised to the upside since then. The Fed is particularly concerned that sticky service prices are rising rapidly, like in-home healthcare, car repairs, and car and home insurance.

These are signs of the momentum that has built up in inflation since 2020. Less concerning for the Fed but no less frustrating for consumers, gasoline prices are up this year, too, fueled by fears that wars could disrupt global oil supplies. Prices of chicken and beef have risen as well as bird flu forced farmers to cull herds.

Inflation is still running too hot to meet the Fed’s mandate for stable prices, but the other half of their dual mandate—maximum employment—is looking increasingly like the pre-pandemic normal. The unemployment rate edged up to 3.9% in April and tied for the highest since early 2022, as employers added a smaller-than-expected 175,000 jobs.

Other measures of the job market, like job openings, the quits rate, and surveys which show consumers are less confident in their employment prospects, collectively point to an even softer job market than the unemployment rate. Average hourly earnings growth for private-sector workers has slowed to the least since mid-2021, with pay for public sector and unionized workers rising faster than pay for un-unionized private workers after un-unionized private workers secured faster wage increases in 2022 and 2023.

Comerica’s May forecast anticipates the Fed waiting until September to make a first quarter-percentage-point cut to the federal funds rate, followed by another cut in December. This is a later and smaller reduction in interest rates than Comerica’s April forecast, which saw three quarter-percentage-point cuts in 2024. The Fed will likely end balance sheet reductions in the first half of 2025, when total Fed assets reach between $6.6 and $6.9 trillion.

Bill Adams is a senior vice president and chief economist at Comerica. Waran Bhahirethan is a vice president and senior economist at Comerica.