The Federal Reserve has begun drafting plans to shrink the size of its balance sheet, which has ballooned during the pandemic as it sucks up government bonds in an attempt to avoid an economic collapse.

The Fed now holds just under $9 trillion in assets, more than double the amount it launched in early 2020 with an unlimited bond-buying program to shore up markets and reduce long-term borrowing costs for businesses and households facing a financial crisis.

Minutes of the Fed’s December policy meeting released last week showed policymakers had begun their most comprehensive discussions yet on how they intend to manage the process of reducing the size of their balance sheets.

The minutes also showed that officials believe the Fed may need to raise interest rates “at a faster pace” It has since sparked wild swings in financial markets as investors became more sensitive to the central bank’s sudden turn to tighten monetary policy.

This week, the real yield on U.S. Treasury bonds, adjusted for inflation, surged to the highest level since June as traders prepared to trim the Federal Reserve’s balance sheet. Real yields affect every corner of financial markets and become the equation investors use to value assets ranging from stocks and bonds to real estate.

Here’s a guide to how the Fed is managing the process of reducing its portfolio and why it matters to the market.

Why is the Fed talking about its balance sheet now?

under pressure Coping with soaring inflation, the Federal Reserve has announced plans to withdraw its $120 billion monthly bond-buying program that it implemented at the start of the pandemic.

The central bank is expected to stop buying bonds in March, paving the way for it to start tightening policy by raising interest rates this year. Most Fed officials now expect three quarter-cent hikes this year and five more by the end of 2024.

Shrinking the balance sheet would be another way to reduce the Fed’s injection of stimulus into the economy, which officials believe must be done given the rise in consumer prices and the strength of the recovery.

“If the economy is doing so well, it’s hard to justify why the Fed maintains such a large balance sheet,” said Roberto Perli, a former Fed staffer and head of global policy research at Cornerstone Macro.

What’s the plan to reduce it?

The Fed has yet to make any final decisions on shrinking its balance sheet, but minutes from its December meeting showed widespread support for a relatively quick reduction after the first rate hike.

The process should be quicker than the Fed’s previous attempt to reduce its holdings in 2017, which was inflated by bond purchases following the 2008 global financial crisis.

At the time, the Fed waited about two years after raising rates for the first time in the post-crisis period before it stopped reinvesting earnings from maturing U.S. Treasury securities and agency mortgage-backed securities (MBS), a process known as “runoff.”

The Fed believes it can act sooner thanks to a “stronger economic outlook, higher inflation and a larger balance sheet,” in stark contrast to the relatively tepid recovery after the financial crisis.

Even after the Fed slashes its balance sheet, it could still be much bigger than it was before 2008, said Mark Spindel, chief investment officer at MBB Capital Partners. Spindel said the prospect of getting it back to its pre-crisis size of less than $1 trillion is a ship that has “sailed a long time.”

In fact, according to the minutes, Fed officials supported a monthly cap, which would limit the speed at which the runoff could take place to ensure a “measurable and predictable” pace. Some also backed the Fed to reduce its holdings of agency MBS more quickly than its vast treasury bonds.

For now, at least, Fed officials appear to be focused solely on shrinking the balance sheet by not replacing bonds that mature and do not appear to be discussing outright asset sales.

Why is the market on the edge?

While the Fed has announced the end of its bond-buying program and telegraphed an imminent rate hike, the sudden talk about its balance sheet caught investors off guard.

The last time the central bank tried to shrink its balance sheet, it turmoil Because it is clear that too much cash has been drained from the financial system.

In 2019, two years after it began shrinking its Treasury portfolio after the last crisis, short-term funding costs soared. This was further exacerbated by the reluctance of banks, which partly filled the gap by buying U.S. Treasuries, to lend cash to overnight lending facilities.

The Fed was forced to intervene, injecting billions of dollars into the so-called repo market and embarking on a series of monthly asset purchases.

Investors aren’t worried about an outright repeat of the repo crisis, but every time the Fed withdraws stimulus, it could have unintended consequences.

With its unlimited asset-purchase program, the Fed has left a sizable footprint on the $22 trillion U.S. Treasury market, the backbone of the global financial system. As it acquired U.S. government debt during the pandemic, it became one of the largest holders of Treasury inflation-protected securities, or Tips, pushing yields into negative territory. It now owns more than a fifth of its $1.7 trillion in debt.

If the Fed starts selling these bonds, the supply of Tips in the market is expected to surge, pushing up their yields (i.e. real yields). Given that real yields are used as a marker for pricing almost all securities in the United States, this could reverberate across every corner of financial markets.

Investors first saw this last week, when real yields surged sharply, sparking speculative selling tech stocks Highly sensitive to interest rates.The move accelerated on Monday, further weighing on risk assets, with the tech-heavy Nasdaq falling to technical correction Because it is down 10% from its all-time high.

“One of the most important questions for the market in 2022 is the outlook for real yields,” said Deutsche Bank’s George Saravelos. “It is the ‘glue’ that holds the market system together.”

Will it have an impact on liquidity in the Treasury market?

The main obstacle to a rapidly shrinking balance sheet is the resilience of the U.S. Treasury market and its ability to function properly when its biggest buyers start to retreat.

Fed officials recently expressed concern, highlighting the “fragility” of the world’s most important bond market and how those weaknesses could affect the speed of its retreat.

“Liquidity is not the same as it was 10 years ago,” said Priya Misra, head of U.S. rates strategy at TD Securities.

The Fed has implemented new tools aimed at mitigating potential problems, including a permanent facility that allows eligible market participants to exchange U.S. Treasuries and other ultra-safe securities for cash at fixed rates.

The standing repo facility was launched in July to support the market and avoid a repeat of the volatility that occurred during the last attempt to shrink the balance sheet.