This Wednesday, officials are due to announce plans for how they will reduce those holdings. Expect the process to be quicker and potentially more disruptive to financial markets than last time.
The Fed first undertook large-scale bond purchases, called “quantitative easing,” during and after the 2007-2009 financial crisis. At a time when the Fed’s short-term interest rate was close to zero, the purchases were aimed at stimulating economic growth by lowering long-term interest rates and pushing investors into riskier assets, supporting stocks, corporate bonds and real estate. She stopped expanding her portfolio in 2014, reinvesting proceeds from maturing securities into new ones, dollar for dollar.
In 2017, when the Fed concluded that stimulus was no longer needed, it began passively shrinking its portfolio, i.e. allowing bonds to mature without reinvesting the proceeds, rather than actively selling them on the open market.
This time, officials again opted for a mostly passive approach so investors wouldn’t have to guess from meeting to meeting about how the Fed might recalibrate its bond purchases.
But passive redemptions, also called trickle-down, will be bigger and faster than five years ago. Then, worried about how the trickle-down would work, officials imposed a low cap of $10 billion on monthly trickle-down and slowly increased that cap to $50 billion over the course of a year.
Officials recently indicated that in this round, they would allow $95 billion in securities to mature each month – $60 billion in Treasuries and $35 billion in mortgage-backed securities – which is almost double the ceilings of the last time. Runoff is expected to begin in June and reach new highs in just a few months instead of a year.
“It was bolder than I expected,” said Eric Rosengren, who served as Boston Fed chairman from 2007 until last year.
Another change is that in September 2017, the Fed briefly suspended rate hikes when it launched the run-off to avoid doing too many things at once. He hoped the program would not attract much attention; one manager joked it would be like “watching the paint dry”.
This time the runoff will begin as the Fed quickly raises rates. Authorities raised rates by a quarter of a percentage point in March, and this week are expected to approve a half-point rate hike, the first in 22 years.
The Fed was in no rush five years ago because inflation was just below its 2% target. The runoff was driven in part by political considerations. Large holdings had become unpopular with some members of Congress who believed these unconventional stimulus tools hid the costs of large budget deficits. To ease those concerns, officials wanted to prove they could reverse quantitative easing.
This time the Fed is in a rush to remove stimulus as inflation was 6.6% in March using the Fed’s preferred index, near a four-decade high.
“I don’t think it’s going to be ‘watching the paint dry,'” said Diane Swonk, chief economist at Grant Thornton. “The Fed is doing this at the same time that they are aggressively raising rates and inflation is high. They want to tighten financial conditions.
Piper Sandler economists estimate the Fed will shrink its balance sheet by about $600 billion this year and $1 trillion next year. Officials speak of a reduction in holdings of around $3 trillion over the next three years, compared to just $800 billion between 2017 and 2019.
Five years ago, the Fed never seriously considered active bond sales on top of passive trickle-down. In contrast, in March, officials agreed that they may eventually have to sell some mortgage bonds on the open market.
The reason for this is that as mortgage rates rise, borrowers are less likely to refinance into a new loan, and therefore mortgage-backed securities are slower to mature. This means the Fed may not be able to significantly reduce its mortgage holdings through runoff alone.
Active sales could contribute to higher mortgage rates this year. By some measures, the spread between mortgage-backed securities and Treasury yields is the widest since 2008, said Michael Fratantoni, chief economist at the Mortgage Bankers Association.
In March, Fed Chairman Jerome Powell equated the effect of this year’s balance sheet reduction to an additional quarter-percentage-point hike in the central bank’s short-term benchmark rate.
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JPMorgan Chase & Co. analysts estimated that every $1 trillion purchase of Fed bonds during and after the 2008 financial crisis reduced the term premium – the extra return investors get for holding of a 10-year Treasury bill – from 0.15 to 0.2 percentage points. The runoff should, in theory, stimulate the term premium by increasing the supply of bonds, lowering their prices and increasing their yields, which move in an inverse relationship to prices.
Some studies show that the biggest effect of bond purchases did not come from reducing the supply of bonds, but signaled that the Fed would not raise interest rates for some time. If so, increasing the supply of bonds through liquidation might have little effect.
The reality is that no one is entirely sure of the impact on growth and markets of a rollback of quantitative easing. This ambiguity complicates the Fed’s calculations of how high to raise interest rates to slow the economy and lower inflation.
“When people talk about the need for the Fed to raise short-term rates, it depends on how much the balance sheet amplifies short-term rate hikes,” Ms. Swonk said. “Even the people who have been closest to designing these programs don’t seem to share a consensus.”
Write to Nick Timiraos at [email protected]
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