Friday, April 07, 2017
The Fed is About to Perform a High Wire Balancing Act With No Net
During the 2008 financial crisis, the Federal Reserve took the dramatic step of initiating quantitative easing, or QE, after determining that dropping its key interest rate to zero wasn’t sufficient.
Following three successive rounds of these Treasury and mortgage bond purchases, the Federal Reserve’s balance sheet ballooned to $4.5 trillion. That amounted to a fourfold increase from late 2008 to late 2014.
However, minutes from the Fed’s March meeting reveal that the central bank now plans to start selling off some of those assets this year, which is expected to drive up long-term interest rates.
The Fed has never done anything remotely like this before; it is in uncharted waters. There is no map for unwinding $4.5 trillion. No central bank has ever attempted anything so audacious and grand.
Though the Fed says the reductions will be “gradual and predictable,” and will be accomplished by “phasing out” reinvestments (meaning it won’t abruptly stop reinvesting these assets when they mature), its actions will undoubtedly send shock waves through markets.
While the Fed hasn’t actively increased its portfolio since ending QE3 in 2014, it has continued to roll over maturing Treasuries and reinvest principal payments from the mortgage-backed securities. If the Fed simply ceases to reinvest the payments it earns on these securities as they mature, that would automatically shrink its balance sheet.
The Fed raised its key rate, the federal funds rate, a quarter point in March, as well as in each of the last two Decembers (2015 & 2016). As of April 5, the funds rate stood at 0.91 percent. It had been stuck at a range of 0-0.25 percent from December 2008 to December 2015.
The federal funds rate — an overnight lending rate between banks — affects short term rates. Adjusting it higher or lower is the lever the Fed exercises to affect other short-term interest rates.
Though short-term rates are the most sensitive (or reactive) to changes in the funds rate, longer term interest rates can ultimately be affected as well, most especially in this instance.
Federal Open Market Committee members say they expect to make two more hikes in 2017 and three in 2018. But the Fed may not have to engage in any further increases to the funds rate if the unwinding of its balance sheet begins to tighten, as expected.
Releasing its long-term securities to the public would push down their prices and drive up their yields (bond prices and yields move in opposite directions).
The Federal Reserve does not typically control long-term interest rates. The market forces of supply and demand determine the pricing for long-term bonds, which set long-term interest rates. However, when the Fed begins to unload some of its long term bonds, that will begin increasing long-term interest rates.
To be clear, though the Fed doesn’t usually control long-term rates, the shrinking of its balance sheet will surely increase the yields of government bonds with longer maturities. When there is copious supply, prices fall and yields rise.
“The Fed’s portfolio includes $426 billion of Treasury securities set to mature in 2018, and $352 billion more that will mature in 2019,” reports Bloomberg, which is on top of the $164 billion of securities that will mature this year.
The Fed will attempt to manage this process as smoothly, cautiously and predictably as it possibly can. But shrinking its balance sheet could prove to be uneven and cumbersome.
When the Fed finally ended QE in October 2014, it did so in a measured and predictable manner, gradually lowering its bond purchases by $10 billion per month. When the central bank began to “taper” in December 2013, it was buying a whopping $85 billion of securities per month. By October 2014, those purchases had ended.
Similarly, the Fed will need to publicly commit to reducing its balance sheet by a certain dollar amount each month.
However, in order to do so, the economy must continue to at least hold steady, if not improve. An economic downturn would send the process into disarray and, ultimately, reversal.
In the meantime, when the biggest buyer of Treasuries and mortgage securities exits the market, mortgage rates are sure to rise. So will the borrowing costs of the federal government.
Additionally, when the Fed stops rolling over its securities, the Treasury will have to raise cash to pay back the Fed for those maturing securities.
That will cost the American taxpayers hundreds of billions of dollars.