By Mark Felsenthal
WASHINGTON (Reuters) - If it's QE2 and through, will the Federal Reserve soon start letting the air out of its balance sheet balloon as well?
The Fed's improved view of the U.S. recovery and heightened vigilance on inflation suggest it will wrap up its monetary easing once it completes its $600 billion bond buying program -- dubbed QE2 because it is the second round of quantitative easing -- at mid-year.
The next important decision for the U.S. central bank is whether to hold the size of its $2.5 trillion balance sheet steady by reinvesting securities as they mature or are paid off, or do nothing, allowing the balance sheet to shrink of its own accord.
That decision -- effectively whether to adopt a neutral policy stance or begin the process of tightening, even if only passively, right away -- will offer a critical signal to markets of how quickly policymakers will shift to a more active effort to remove support for the economy.
Most observers expect the Fed to pull back on its easing first by draining reserves from the financial system through reverse repurchase agreements or short-term deposit arrangements, and then by raising benchmark interest rates.
Markets anticipate rate increases in the second half of next year, and analysts say assets sales would follow.
Right now, economists expect the Fed to make an effort to prevent its balance sheet from shrinking at least until year end.
Whether to hold it steady or allow tightening right away will communicate how concerned the Fed might be on inflation risks.
"The Fed rarely if ever moves from easing to tightening. Usually there is a transition period," said Barclays Capital economist Michael Gapen. "If you're already moving to a position where you're passively tightening, then you must be thinking that there's some need to increase the funds rate sooner than you had previously thought."
Gapen expects the Fed to hold the size of the balance sheet steady through the end of this year, and in early 2012 to allow it to decline over three to six months. The Fed would also begin to drain reserves from the financial system through reverse repurchase agreements and other tools.
Under that scenario, the Fed would raise short-term interest rates in the fall of next year.
"Stronger data, better job growth accelerates that time table; a dampening of the growth profile pushes that time-line out," he said.
The Fed went through a balance sheet maintenance process before, in the opposite direction, as it prepared another round of easing to support a flagging recovery in the middle of last year.
Normally, the Fed controls the pace of economic growth through short-term interest rates, which it lowers when it wants to accelerate and raises when it wants to slow down.
But as the financial crisis and recession unfolded, the Fed chopped benchmark borrowing costs to near zero in December 2008. With short-term rates as low as they could go, the central bank started buying longer-term, highly liquid assets -- mortgage-related debt and Treasuries -- in a continued effort inject liquidity to boost growth.
Most economists believe that tactic was successful. However, it swelled the Fed's balance sheet from around $900 million before the crisis to around $2 trillion.
After the Fed's first round of large-scale asset buying ended in March 2010, policymakers let the balance sheet shrink. That reflected the view that the recovery was picking up, as well as a desire to reverse the central bank's massive participation in housing markets through its purchase of mortgage-backed securities and housing finance agency debt.
But faced with a rapid decline in the size of the balance sheet, driven by a mortgage refinancing boom, the Fed reversed course in August, announcing it would reinvest the proceeds of maturing mortgage-related debt into Treasuries.
Letting the balance sheet get smaller of its own accord as early as July would signal that the Fed has moved immediately to tightening mode. Financial markets would likely pull forward expectations of rate hikes and perhaps even of outright asset sales.
Investors who had moved to riskier assets as the Fed bought longer-term highly liquid securities such as Treasuries and housing-related debt would move back to those securities, raising borrowing costs for corporate bonds and other types of securities.
"If the forecasts prove correct -- ongoing strength and momentum going through (the second quarter of 2011) -- then the prevailing view may be to let more of this run off," said Eric Green, an economist with TD Securities.
He believes the Fed could adopt a back-door implicit tightening by reinvesting proceeds only from its mortgage-related debt while allowing maturing Treasury securities from its balance sheet to roll off. An added advantage of this strategy would be to pare housing-related debt.
"They have too much MBS. They'll be dealing with that for years to come," said Green.
Analysts estimate the balance sheet would decline by $12 billion to $15 billion a month if the Fed did not reinvest proceeds from mortgage-backed securities that mature or are prepaid.
Barclays' Gapen estimates unchecked portfolio run-off in 2012 would total around $317 billion, including about $151 billion from Treasury securities, $131 billion from MBS and $28 billion from mortgage agency debt.
Analysts estimate a reduction in the Fed's portfolio of $300 billion is equivalent to somewhere close to a half percentage point of short-term interest rate increases.
(Reporting by Mark Felsenthal; Editing by Dan Grebler)