This Wednesday, officials are due to announce plans for how to reduce those holdings. Expect the process to be faster and potentially more disruptive for financial markets than last time.
The Fed first did large-scale bond buying, which it called “quantitative easing,” during and after the 2007-2009 financial crisis. At a time when the Fed’s short-term interest rate was near zero, the buying was designed to stimulate economic growth by lowering long-term interest rates and pushing investors into riskier assets, booming stocks, corporate bonds and real estate. It stopped expanding its portfolio in 2014, and reinvested the outstanding securities proceeds in new contracts, dollar for dollar.
In 2017, when the Fed concluded that stimulus was no longer necessary, it began passively shrinking its portfolio — that is, by allowing bonds to mature without reinvesting the proceeds, rather than actively selling them in the open market.
This time around, officials once again opted for an essentially passive approach so investors don’t have to guess from one meeting to the next how the Fed might reset bond redemptions.
But negative recoveries, also known as runoff, will be larger and faster than they were five years ago. Then, concerned about how runoff would work, officials imposed a low cap of $10 billion on monthly runoff and slowly raised that limit to $50 billion over a year.
Officials recently indicated that in this round, they will allow $95 billion in securities to mature each month — $60 billion in Treasury and $35 billion in mortgage-backed securities — nearly double the caps than last time. The runoff is likely to start in June and hit new caps in just a couple of months instead of a year.
“She was much bolder than I expected,” said Eric Rosengren, who was chair of the Boston Federal Reserve from 2007 until last year.
Another change is that in September 2017, the Fed briefly held off its rate hike when it launched its run-off to avoid doing too many things at once. He hoped the program would not attract too much attention; One official quipped that it would be like “watching the paint dry.”
This time around, the runoff will start while the Fed quickly raises interest rates. Officials raised rates by a quarter of a percentage point in March, and this week is due to approve a half-point rate increase, the first in 22 years.
The Fed was in no hurry five years ago because inflation was just below its 2% target. Runoff was driven in part by political considerations. Large holdings became unpopular with some members of Congress who believed that these unconventional stimulus tools were masking the costs of severe budget deficits. To allay these fears, officials wanted to prove they could reverse quantitative easing.
This time around, the Fed is in a hurry to remove the stimulus because inflation was 6.6% in March using the Fed’s preferred index, close to a four-decade high.
“I don’t think this is going to be ‘watching the paint dry.’” said Diane Sonic, chief economist at Grant Thornton. “The Fed is doing it at the same time they are aggressively raising interest rates and inflation is high. They want to tighten financial conditions.”
Economists at Piper Sandler estimate that the Fed will shrink its balance sheet by about $600 billion this year and $1 trillion next year. Officials talk about shrinking holdings by about $3 trillion over the next three years, compared to just $800 billion between 2017 and 2019.
Five years ago, the Fed did not seriously consider active bond selling in addition to negative runoff. By contrast, officials agreed in March that they may eventually need to sell some mortgage bonds in the open market.
The reason is that as mortgage rates rise, borrowers are less likely to refinance into a new loan, so mortgage-backed securities are slower to mature. This means that the Fed may not be able to reduce its mortgage holdings much through runoff alone.
Active sales could add to the rise in mortgage rates this year. By some measures, the spread between yields on mortgage bonds and Treasurys is the widest since 2008, said Michael Fratantoni, chief economist at the Mortgage Bankers Association.
In March, Fed Chairman Jerome Powell equalized the effect of this year’s balance sheet shrinkage with an additional quarter-percentage point increase in the central bank’s short-term benchmark rate.
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Analysts at JPMorgan Chase & Co estimated that every $1 trillion in Federal Reserve bond purchases during and after the 2008 financial crisis lowered premiums — the extra yield investors get for holding 10-year Treasuries — by 0.15 to 0.2 percentage points. Runoff is supposed, in theory, to increase insurance premiums by increasing the supply of bonds, driving their prices down and raising their yields, which move in an inverse relationship with prices.
Some studies show that the biggest effect of bond buying was not achieved by reducing the supply of bonds, but by indicating that the Fed won’t raise interest rates for a while. If so, increasing the bond supply by runoff may have little effect.
The truth is that no one is quite sure of the impact on growth and markets as a result of QE reversal. This uncertainty complicates the Fed’s calculations about how much interest rates will rise to slow the economy and lower inflation.
“When people talk about the Fed needing to raise short-term rates higher, it depends on how much the balance sheet is inflating to higher short-term rates,” said Ms. Sonk. “Even the people who were closest to designing these programs don’t seem to share a consensus.”
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