Over the past few months, the investment community has begun focusing on the steps the Federal Reserve might take to reduce its current balance sheet, which now amounts to some $4.3 trillion.

Because the economic consequences would have a global impact, including a likely increase in interest rates in the intermediate and long-term bond markets by one to two percentage points, the Federal Reserve has sought feedback from bond fund managers on how it should tailor and communicate the sale of its record holdings of Treasuries and mortgage-backed securities.

A likely consequence of an increase in U.S. interest rates is a stronger dollar, which would encourage capital inflows, decrease U.S corporate profits and dampen our economy.

In a move called “Quantitative Easing,” the Fed began large-scale purchases of assets such as U.S. Treasuries and government–supported mortgage-backed securities to prevent our financial system from collapsing in late 2008. Over the next six years, the Fed continued adding to its balance sheet.

Most economists believe that Quantitative Easing stabilized our financial system and stimulated our economy, avoiding the worst recession since the Great Depression.

Quantitative Easing:

• Reduced interest rates to record lows.

• Encouraged bank lending and consumer spending.

• Increased stock and bond prices.

Critics of Quantitative Easing had argued that the Fed policy would create an asset bubble. Fortunately, to date, we have seen no evidence of an imminent asset price collapse in either the stock or the real estate markets.

In the course of Quantitative Easing, the Fed’s balance sheet increased from about $900 billion to $4.3 trillion — $2.5 trillion in treasuries and $1.8 trillion mortgage-backed securities.

On October 29, 2014, Federal Reserve Chairwoman Janet Yellen announced the end of this bond-buying program. But the Fed has kept the size of its balance sheet constant and is buying just enough bonds and mortgages to replace maturing securities. Yellen took this step largely because of improvements in our labor market and rising prices. Inflation now is approaching the Fed target of 2 percent.

The next step is to shrink the Fed’s balance sheet. It would be fantastic if our economy could grow despite an expected increase in our interest rates. Essentially, our economy then would be enjoying normal economic growth without crutches.

In September 2014, the Fed said it would reduce its holdings by not reinvesting when their holdings matured because its policymakers felt that selling their holdings outright would probably be too disruptive and cause a spike in interest rates.

On Jan. 26, 2017, former Fed Chairman Ben Bernanke, in a blog post entitled “Shrinking the Fed’s balance sheet,” recommended that the Fed provide some guidance about the ultimate size and composition of its balance sheet. “If the Fed lets the balance sheet shrink by remaining passive and predictable, the risk to the market should be minimal,” he wrote.

Bernanke said that he does not believe that the Fed’s balance sheet should decline precipitously. He feels that the growth in our economy since 2008 warrants a larger balance sheet than the historical normal amount of under $1 trillion. While not appropriate today, Bernanke said he believes that, in time, the U.S. economy will be large enough to justify a $4.5 trillion balance sheet.

While I recognize that the $4.5 trillion Fed balance sheet seems bloated, I agree with the Fed position that it must be cautious in reducing it. There is no evidence that its current size has posed significant problems for our economy.

I also agree with Bernanke’s recommendation of a passive runoff of maturing assets rather than varying the pace for policy purposes. We must realize that the downside of increasing our interest rate levels too much is that it would raise the interest costs of funding our national debt, which currently totals about $20 trillion.

In other words, rising interest rate costs would divert funds from other worthwhile government spending objectives.

Originally published in the Sarasota Herald-Tribune