Fed Debate Heats Up Over the Size and Composition of Its Bond Holdings
By Nick Timiraos
Discussions inside the Federal Reserve are heating up over what the central bank's portfolio of bonds and other assets will look like when it is done shrinking those holdings.
The talks suggest the Fed is leaning toward carrying a larger portfolio than seemed likely a few years ago, and that those holdings could be weighted toward short-term Treasury securities, according to minutes of the central bank's December policy meeting released Wednesday. Some officials also want to hasten their disposal of mortgage securities by selling small amounts.
"When we announced the normalization plans, the idea was to bring the balance sheet back to an all-Treasurys portfolio," said Cleveland Fed President Loretta Mester in an interview last week. "That's part of the discussions.... What would that look like? How would we go about doing it?" Officials want to make sure "the markets will be able to handle it, " she said.
President Trump has called on the Fed to stop shrinking its portfolio and some investors argue the Fed's shrinking bond portfolio is disrupting markets.
The central bank unleashed several rounds of bond purchases to push down long-term rates during and after the financial crisis, swelling its portfolio of bonds and other assets to more than $4.5 trillion in 2014 from less than $1 trillion before 2008. In late 2017, it started allowing some holdings to mature without replacing them, shrinking its holdings to $4.1 trillion last month. They are on a path to reach $3.5 trillion by mid-2020.
Fed Chairman Jerome Powell has said the central bank doesn't believe the portfolio runoff has contributed to recent market volatility, but the Fed could tweak the runoff if officials come to a different conclusion. For now, officials are reluctant to stray from their broader effort to pare down their holdings.
The path the Fed chooses will be dictated in part by operational questions, and not considerations about the broader economy.
The Fed used to move around its target interest rate -- the federal-funds rate -- by altering the level of reserves in the banking system. Reserves are deposits of money banks keep with the Fed.
The central bank moved away from its approach during the financial crisis when it flooded the financial system with money while buying bonds, leaving with trillions of dollars worth of reserves. Now, as the Fed's portfolio shrinks reserves are also diminishing.
If officials decide to permanently abandon the old way of managing the federal-funds rate, they can leave reserve levels and the broader portfolio larger than in the past. Several have indicated they are content to maintain a system with abundant reserves.
"The current system for policy implementation...has, to date, served us well," said Fed Vice Chairman Richard Clarida in a speech Thursday night in New York.
Earlier Thursday, Mr. Powell said it was too soon to say how large the portfolio would be when the Fed ended the runoff. "It will be smaller than it is now but nowhere near what it was before," he said.
Last month, Fed officials considered two options for how much to let the securities portfolio shrink.
Under one scenario, they would let securities run off until reserves became scarce enough in the banking system to start putting some upward pressure on their benchmark rate. Under another scenario, the Fed would stop the runoff before reserves became that scarce.
The difference between the two scenarios could be a portfolio of slightly more than $3 trillion versus a portfolio of $3.5 trillion, said Seth Carpenter, chief U.S. economist at UBS and a former Fed economist.
Around half of Wall Street banks surveyed by the New York Fed last month said they expected the portfolio to stop shrinking by the second quarter of 2020.
The Fed also has to decide on the kind of Treasury securities it will hold.
Fed policy in the past decade operated on the theory that holding long-term securities stimulates financial markets and the economy by holding down long-term rates. Holding long-term Treasury securities in theory drives investors into riskier assets such as stocks and corporate bonds. Holding short-term securities, the thinking goes, provides little stimulus.
The latest minutes indicate a few officials supported maintaining a portfolio of bills, notes and bonds in proportions that reflect the outstanding Treasury market. This approach would have a neutral effect on the Treasury market.
More officials, however, appear to favor weighting their holdings toward Treasury bills and other shorter-maturity holdings, the inverse of their crisis-era interventions into long-term bonds.
This would be a less-stimulative approach to financial markets and would provide less support to the economy, but it would also make it easier for the Fed to quickly stimulate growth by shifting back into long-term securities in any downturn.
Fed officials also discussed instituting a program of very gradual sales of mortgage bonds once the size of the balance sheet has stabilized.
The central bank is allowing up to $20 billion in mortgage bonds to run off the portfolio every month, but the actual amounts have been less than that because fewer homeowners are refinancing, leaving fewer mortgage bonds to mature.
Analysts at JPMorgan Chase expect the Fed could still hold $1 trillion in mortgage bonds in 2021, once they are done shrinking the portfolio. At the recent pace of refinancing, it could be a decade before the Fed's holdings shrink to $500 billion, which has sparked the idea of modest outright sales.
Under the plan, the Fed would replace mortgage securities that are removed from the portfolio with Treasury securities once the portfolio size is stabilized.
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