Federal Reserve Chair Janet Yellen has said she wants to shrinkthe central bank's $4.5 trillion balance sheet in an “orderly andpredictable way” that limits risks to the economy. The hurdles togetting that done are high.

The economic impact, the pace of the drawdown and its ultimateend point are all partly subject to forces beyond the Fed'scontrol. That could mean that the financial markets and the economymay be in for more tumultuous times than Yellen and her colleaguesare hoping for.

“We don't really know how it's going to go,” said RichardClarida, global strategic adviser for Pacific Investment ManagementCo., which oversees $1.5 trillion in assets. “There's not all thatmuch precedent” for the position that the Fed finds itself in.

Policy makers probably will deepen their discussion about whenand how to pare the central bank's big bond holdings at a two-daymeeting of the Federal Open Market Committee starting Tuesday. TheFOMC is expected to leave its interest-rate target range unchangedafter raising it in March to 0.75% to 1%.

The reaction of the financial markets to the Fed's emergingbalance-sheet strategy so far has been muted, boosting policymakers' hopes that the drawdown can go off without much trouble.Most FOMC participants in March envisaged that the central bankwould begin the process of reducing its holdings of Treasury andmortgage-backed securities later this year, according to theminutes of that meeting.

Fed officials maintain that forward-looking investors havealready taken the coming decline into account so that the market'sreaction to its actual start should be limited.

Still, some Fed watchers argue that the Treasury Department willhave a greater say than the Fed in determining the impact of areduction in the central bank's $2.5 trillion portfolio of U.S.government securities. That's because the department has to decidehow to make up for the financing it will lose when the Fed beginsto allow bonds to roll off as they mature rather than reinvestingthe proceeds.

And so far it's not clear what Treasury will do, although someclues may surface this week.

Investors may get some insight into the Treasury's plans whenthe department announces on May 3 the size of its quarterly bondand note auctions — the so-called refunding announcement in whichshifts in debt-management plans are often telegraphed. TreasurySecretary Steven Mnuchin has raised the possibility of the U.S.issuing 50-year or longer-dated bonds to take advantage of lowinterest rates.

A possible fourth-quarter launch of a 50-year bond to coincidewith a reduction in the Fed's balance sheet might make sense,according to Gemma Wright-Casparius, who makes trading decisionsfor more than $60 billion in U.S. government debt portfolios atVanguard Group Inc. It's “a good time to kind of marry the twotogether,” she said.

If the government issues more bills, it would effectively be a“freebie” for the financial markets and the economy, according toLou Crandall, chief economist at Wrightson ICAP. Short-terminterest rates would remain anchored by the Fed and so wouldn't bemuch affected by the added supply of bills.

But if the Treasury opts to issue more longer-dated securitiesinstead, that would put upward pressure on Treasury and corporatebond yields and mortgage rates, with implications for the housingmarket and the broader economy.

“A lot depends on how the Treasury reacts,” Fed vice chairmanStanley Fischer acknowledged in an April 17 appearance at ColumbiaUniversity in New York, adding, “I don't know what they willdo.”

Fischer argued though that any Treasury move wouldn't be a bigproblem for the Fed because the central bank could adjust what it'sdoing with the federal funds rate in response to what happens inthe financial markets.

Complicating the Fed's task is its desire to sharply reduce itsholdings of $1.8 trillion in mortgage-backed securities. Manyparticipants at the FOMC's March meeting stressed that thereduction in the balance sheet “should be conducted in a passiveand predictable manner,” according to the minutes. Yet that's notpossible when it comes to mortgage-backed debt, Pimco's Claridasaid.

Mortgage Securities

Such securities can unexpectedly come due early if homeownersdecide to move or to refinance their mortgages. So if the Fed wantsits drawdown to be predictable, it will have to actively manage itsholdings and not just passively accept what happens in themarket.

“Some of their goals are potentially in conflict,” agreed MikeFratantoni, chief economist at the Mortgage BankersAssociation.

He worries about volatility in the market in the coming monthsas Fed policy makers debate their balance sheet plans.

Once the rundown begins, Fratantoni sees the 30-year fixedmortgage rate rising to more than 5% next year, from 4.2% now. Thespread between that rate and the 10-year Treasury yield will likelywiden by 10 to 20 basis points from about 180 basis pointscurrently, he added.

While the Fed has made clear its desire to rid itself of much ofits mortgage-backed debt, it's not been so forthcoming on how farit wants to reduce its asset holdings overall. Yellen toldlawmakers on Feb. 14 that she foresaw a “substantially smaller”balance sheet, though she also said, “I can't put a number onthat.”

Her predecessor, Ben Bernanke, told CNBC television Monday thathe thinks the Fed will aim for a balance sheet totaling $2.3 to$2.8 trillion.

Whether the drawdown goes smoothly or not, the eventual size ofthe balance sheet will be partly determined by global demand forcash, which is outside the Fed's control. It will also be affectedby how much reserves commercial banks want to hold, said former Fedofficial Eric Swanson.

“It's nice for the Fed to be clear, but in this case they can'tbe,” said Swanson, now a professor at the University of California,Irvine.

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