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Fed Grapples With Massive Portfolio
Years after the financial crisis, central bank considers what to do with holdings of long-term bonds and other assets
While Federal Reserve officials ponder when to raise short-term interest rates again, they are beginning to wrestle with another big policy decision—whether this is the year to start shrinking their immense portfolio of mortgage and Treasury securities.
The Fed has boosted its portfolio of long-term bonds and other assets to $4.45 trillion from less than $1 trillion in 2007, just ahead of the financial crisis. Officials believe the large portfolio has helped to spur economic growth by holding down long-term interest rates.
With the economy closer to healed from the financial crisis and recession, the central bank has already begun raising short-term rates. Fed Chairwoman Janet Yellen has said the Fed would reduce the bondholdings once interest rate increases were “well under way.” Many officials hope to get the portfolio back to some state of precrisis normalcy.
A great deal is at stake with the bond decision. Shrinking the portfolio could jolt financial markets, pushing up interest costs on government debt and mortgage bonds and reverberating through the broader economy.
Officials don’t know how markets will react when they shrink the holdings because they have never done it before. But they know plenty about the skittishness of investors. When they signaled they would end bond purchases in 2013, they sparked a market “taper tantrum” that sent interest rates higher and hurt emerging markets.
Fed officials hold their next policy meeting Tuesday and Wednesday. They are expected to keep interest rates and their portfolio steady.
The balance sheet debate is still in its early stages, but it is on Ms. Yellen’s mind. In a speech Jan. 19 at Stanford University, she noted the stimulative effects of the Fed’s bondholdings are diminishing over time as the moment nears for the Fed to shrink them. Sheer anticipation of a drawdown of the bonds could push long-term rates higher, she said in a footnote to her comments. That’s a reason to proceed cautiously.
Bond dealers surveyed by the New York Fed in December said they expected the central bank to keep its portfolio steady for another 18 months.
But several Fed officials have said recently the time to start shrinking the balance sheet could come in 2017. This year “might be a good time to play that card,” St. Louis Fed President James Bullard said in a December interview with The Wall Street Journal.
The Fed should raise its benchmark federal-funds rate above 1% “sometime this year,” Philadelphia Fed President Patrick Harker said Jan. 20. Once that happens, “the next step” is to do something to allow the balance sheet to start shrinking, he said.
Boston Fed President Eric Rosengren has also expressed sympathy for the idea.
“We’ve not yet made any precise decisions about when that will occur,” Ms. Yellen said in December.
Fed officials have said for a while they want to raise the fed-funds rate first because they’re most familiar with this tool. They also want it high enough so they have room to cut it later if needed to provide stimulus in response to another economic downturn.
Officials are starting to discuss the balance sheet plans now for several reasons.
First, they don’t see political support for letting it get any bigger. And like the argument about short-term rates, reducing it would give them some room to expand it later if they need to spur the economy.
Some also worry that raising short-term rates is boosting the dollar, which curbs exports and weighs on inflation, which is already below their 2% target. Shrinking the balance sheet instead of raising short-term rates could be a way to tighten financial conditions without bearing the costs of a stronger currency.
Many questions about mechanics loom. Officials have long said they won’t sell their securities, fearful it could jolt to markets. Instead, to shrink the portfolio they will alter their current practice of using the proceeds from maturing bonds to buy new ones, a process called reinvestment.
There are a few of ways they could do this. They could halt all reinvestment. They could reduce the amount reinvested gradually. Or they could start by reinvesting proceeds from long-dated maturities into shorter ones.
They also haven’t decided how big the balance sheet should be when they finish. “We are actively discussing and researching the question,” Mr. Harker said.
A January research note by Fed economists Erin Syron, Soo Jeong Kim and Bernd Schlusche projected the portfolio would decline to $2.7 trillion by 2025.
Former Fed Chairman Ben Bernanke has argued in favor of keeping the securities portfolio large, or reducing it only moderately.
Given changes in the way the Fed manages interest rates and other shifts in markets and the economy, he wrote in a blog post Thursday, “the optimal size” of the holdings could be more than $2.5 trillion currently and could reach $4 trillion or more over the next decade.
“In a sense, the U.S. economy is ‘growing into’ the Fed’s $4.5 trillion balance sheet,” he said, “reducing the need for rapid shrinkage over the next few years.”