Forget Interest Rates, the Fed Has Another Big Decision to Make in the Next Year

What to Look for From FOMC Minutes

In case exiting years of zero interest rates won’t be hard enough, Federal Reserve officials have another challenge approaching quickly: when to begin unwinding trillions of dollars of bond purchases that constitute the world’s largest fixed-income portfolio.

Less than a year from now, the Fed must decide whether to reinvest $216 billion of proceeds from Treasury debt maturing in 2016, or shrink its balance sheet by allowing it to expire. By not reinvesting, the Fed would increase the supply of securities available to investors and put upward pressure on yields.

Shrinking the $4.2 trillion portfolio will add to the monetary tightening from increases in the benchmark interest rate officials envision for this year. That would mark a reversal of the easing the Fed achieved when it bought bonds to speed a recovery from the worst recession since the 1930s.

The timing will be tricky. Fed Chair Janet Yellen, concerned the economy remains fragile, has said the pace of rate increases is likely to be gradual and cautious. A decision to start unwinding the Fed’s bond portfolio could give her more reason to proceed slowly or even stop raising rates for a time, said Drew Matus, deputy U.S. chief economist at UBS Securities LLC in New York.

“From an economist’s perspective, you kind of want one thing happening at a time,” said Matus, a former analyst on the New York Fed’s open-market desk. “Our baseline view is that they keep the pace of rate hikes slow as they are moving toward and into the initial roll-off period, but it’s also possible that becomes a great time for them to pause for six months.”

Zero Rates

The Fed started its unprecedented bond purchases to reduce longer-term borrowing costs after cutting the benchmark federal funds rate almost to zero in December 2008. The central bank bought Treasuries and mortgage debt in three waves of so-called quantitative easing that ended in October 2014.

Officials have said they will probably never sell mortgage debt outright, and they haven’t decided whether to sell Treasuries. They will allow their portfolio to shrink “in a gradual and predictable manner,” mainly by ceasing reinvestments and allowing the portfolio to run off over time as securities mature, according to a September statement.

“When the FOMC chooses to cease reinvestments, the balance sheet will naturally contract,” Vice Chairman Stanley Fischer said in a March 23 speech in New York. “This runoff of our securities holdings will also gradually remove accommodation, an effect that we will need to take into account in setting the stance of policy.”

Overnight Loans

The Fed has good reasons to shrink its balance sheet. Buying securities pumped trillions of dollars of excess reserves into the banking system, making it harder to control the fed funds rate, which represents the cost of overnight loans among banks.

With the rate near zero, that hasn’t been an issue. Now that the Fed expects to raise the rate, it will have to deploy new tools to soak up the excess reserves, increasing the Fed’s role in money markets. Fed officials want to minimize their influence in those markets, while also restoring the effectiveness of the funds rate.

In the longer run, the Fed plans to “hold no more securities than necessary to implement monetary policy efficiently and effectively,” according to the September statement. It will “hold primarily Treasury securities, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy.”

‘Tough Call’

When to start shrinking the balance sheet “is a tough call,” says economist Raymond Stone. That may be especially true as recent data on employment, retail sales and production indicate the economy is slowing.

“You really don’t know how the markets are going to react,” said Stone, of Stone & McCarthy Research Associates in Princeton, New Jersey. If long-term interest rates “rise more than you want, you end up constraining economic activity at a time when we are still struggling a little bit.”

When the first wave of maturities comes due in February 2016, the Fed will have three options: continue reinvesting the principal payments, stop reinvesting, or begin phasing out reinvestments slowly.

Antulio Bomfim, a senior managing director at Macroeconomic Advisers LLC in Washington, said policy makers will probably choose the third approach to soften the blow.

“Instead of going cold turkey, you stretch it out over a period of months, where you are progressively reinvesting less and less,” said Bomfim, a former Fed economist. “By mid-next year, that’s when we see them as being out of reinvestments altogether.”

Getting Started

Still, policy makers will probably want to complete a number of rate increases before they are comfortable getting the process started.

“It’s going to be, at minimum, a year of rate increases before they say, ok, let’s layer on top of that something about the balance sheet,” said William Lee, head of North America economics at Citigroup Global Markets in New York.

Traders in fed funds futures don’t expect the Fed to begin raising rates until December. That may mean the Fed will continue reinvesting principal payments from maturing bonds well into next year.

“Even then, they will not even mess with that until they are sure the markets have gotten acclimated to a rising-rate environment and a tightening environment,” said Lee, a former Fed economist. “And that won’t happen, as far as I can see, until 2017.”

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