Investors May Feel Left Out of Fed’s Plans

The Federal Reserve may hesitate to raise rates again, but still intends to shrink its bond holdings

By Justin Lahart

Federal Reserve Chairwoman Janet Yellen testifying before a Senate Committee in July. Photo: Ron Sachs/CNP/Zuma Press


Can the Federal Reserve take away the punchbowl from the stock market without taking it away from the economy?

The Fed left rates steady at the conclusion of its two-day policy meeting Wednesday and, given worries about low inflation, investors are doubtful whether another rate increase is coming this year. But the central bank doesn’t seem to have any qualms about starting to run down the massive stock of Treasury and mortgage securities that it accumulated in the wake of the financial crisis. It said it plans to do that “relatively soon”—a signal that it could start shrinking its portfolio following its September meeting.

It seems as if the Fed is making its future rate decisions contingent on what inflation does, but that it is happy to go forward with its balance sheet plan so long as the job market continues to do well, says J.P. Morgan Chase economist Michael Feroli. It is a bit of a mystery why.

One possibility is that it wants to get the balance-sheet process under way before Chairwoman Janet Yellen’s term ends in January, helping to make any successor’s move into the job smoother. But the Fed also may be mindful of differences in how rate increases and portfolio reductions might affect the economy.

When the Fed raises rates, it increases banks’ borrowing costs and can make them less willing to extend credit. But when it starts reducing its balance sheet, it will increase the supply of Treasury and mortgage securities on the market, placing upward pressure on their yields. That will make them more attractive relative to stocks and corporate bonds and could reverse an easing in financial market conditions that has come despite the Fed’s rate increases. This has the Fed worried. Indeed, minutes of the its June meeting showed that some policy makers were concerned that investor complacency amid high valuations “could lead to a buildup of risks to financial stability.”

For investors, whether or not financial markets are an element in the Fed’s thinking is beside the point: For whatever reason, it isn’t letting low inflation get in the way of its balance sheet plan. That could make markets more challenging.

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