Fed Says Reducing Bond Portfolio Depends on Economy

The Federal Reserve today opened the door to sustaining a multi-trillion dollar portfolio for years, saying any decision to stop reinvesting maturing bonds would depend on financial conditions and the economic outlook.

Letting the balance sheet run off to levels that the Fed would consider normal “could take to the end of the decade,” Fed Chair Janet Yellen said in a press conference after a meeting of the Federal Open Market Committee today in Washington.

The new exit strategy breaks with the June 2011 plan that made halting reinvestment a first step, to be followed by changes to forward guidance, reserve draining operations, and an eventual increase in the federal funds rate.

Fed officials today endorsed earlier statements that the central bank wouldn’t sell any of its holdings of mortgage-backed securities, another step that assures the balance sheet, which now stand at $4.42 trillion, is likely to remain large for years to come.

The Fed will rely on additional tools to orchestrate its exit from near-zero interest rates because the effectiveness of its benchmark fed funds rate has been sapped by the flood of excess bank reserves it has pumped into the financial system.

The Fed “intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances,” the central bank said in a statement today.

Rate Floor

The Fed has also been testing overnight reverse repurchase agreements with a limited set of counterparties, mostly money funds, as a tool to set a floor under short-term interest rates when it begins guiding those rates higher, an event Fed officials forecast to occur in 2015.

In an overnight reverse repo, the Fed borrows cash from counterparties using securities as collateral. The next day, it returns the cash plus interest to the lender and gets the securities back.

Borrowing through the overnight reverse repo facility will be limited to $300 billion per day, according to a statement on the New York Fed’s website revising the terms of the operations. The per-counterparty limit was raised to $30 billion from $10 billion.

The new cap on the facility’s daily use is below the maximum amount logged on June 30, when the Fed borrowed $339.5 billion through reverse repos. Previously, the Fed did not limit the overall size of the facility.

Some 61 percent of 43 economists in a Bloomberg News survey conducted ahead of today’s meeting said the Fed would have to borrow more than $250 billion per day on average through reverse repos to sustain a floor under the federal funds rate at liftoff, more than double the $121 billion daily average logged in 2014 as the central bank has tested the facility.

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