At Heart of New Fed Debate: Bonds or Bills?
The Federal Reserve must decide how to manage the mix of long-term versus short-term in its Treasury portfolio
By Nick Timiraos
The Fed has decided it wants to hold primarily Treasury securities rather than mortgage securities, but it hasn’t worked out what the mix of those Treasury securities will look like. Photo: leah millis/Reuters
Federal Reserve officials left many important questions unanswered when they decided last year to begin shrinking the central bank’s $4.5 trillion portfolio of mostly mortgage and Treasury securities.
They are now beginning an internal debate to answer one of the most important of those questions: What exactly will this portfolio look like when they are done shrinking it?
The Fed has decided it wants to hold primarily Treasury securities rather than mortgage securities once it is done. But it hasn’t worked out what the mix of those Treasury securities will look like. Will it be mostly very short-term bills? Or will it include a hefty share of longer-term bonds?
The idea was at the core of former Fed Chairman Ben Bernanke’sstrategy to move heavily into long-term Treasury bonds during the financial crisis. Fed estimates suggest the strategy pushed down long-term interest rates by a full percentage point, making it less costly for millions of homeowners, car buyers and corporations to borrow. The mix of long-term and short-term bonds also influences the federal government’s borrowing costs.
Fed officials, led by the Federal Reserve Bank of New York and economists at the Fed board in Washington, D.C., are beginning studies and internal debates on how to manage that mix of long-term versus short-term in the Fed’s Treasury portfolio in the years ahead, according to several people familiar with the matter.
It is among several big questions facing Fed ChairmanJerome Powell,including how big the overall portfolio should be in the long run and what tools should be used to manage short-term rates.
Mr. Powell is uniquely situated to lead the discussions. In the early 1990s as a senior U.S. Treasury official, he oversaw debt-management policy, including questions about how many long-term bonds the government would issue.
The review process and internal debate about the portfolio’s composition is in its early stages and could take months to play out, these people said.
“Everyone has been focused on the final size of the balance sheet, but they are going to have to make an important decision about its composition as well,” saidBrian Sack,who ran the New York Fed’s markets desk from 2009 to 2012 and is now the director of economics at hedge-fund manager D.E. Shaw group. “They haven’t said anything about the composition of maturities for their Treasury holdings.”
Officials said they aren’t in a hurry to finalize their approach. “This is certainly something to think about,” said St. Louis Fed PresidentJames Bullardin an interview. “We’re in good shape now. We have to address this more seriously in the next year.”
The Fed’s options are likely to fall somewhere between two strategies. The first would target a “maturity neutral” approach that maintains a portfolio of bills, notes and bonds in a proportion that mirrors Treasury Department issuance of these securities.
Alternately, officials could weight their portfolio mostly toward Treasury bills and other shorter-maturity holdings, the inverse of their crisis-era interventions into long-term bonds and one that would provide less support to the economy.
At some point, after it has shrunk to a size the Fed finds appropriate, the Fed’s portfolio will start growing again, in line with the economy and money supply’s natural growth. That means the Fed will need a strategy for how it should grow. Complicating the planning, it will take years for the mortgage holdings to passively mature and be replaced by Treasury holdings.
The Fed’s share of shorter-duration securities is much lower now than before the crisis. In 2007, around half of its Treasury securities matured within one year or less, compared with 17% today.
Officials are torn about which strategy would be best.
Concentrating holdings in any single maturity range could distort market functioning. That argues for a mix of short-term and long-term securities holdings that mirrors the supply of securities already in the marketplace.
But spreading holdings broadly across many different maturities means some measure of potentially unwanted stimulus to the economy in the form of long-term holdings. Maintaining an appropriate mix could be complicated if the Treasury shifts the mix of securities it issues, altering the mix of securities in the marketplace.
A portfolio heavily concentrated in bills provides the Fed with operational flexibility. Because bills are so liquid, they can easily be replaced in an emergency and moved into other assets, such as loans through the Fed’s discount window to banks in a crisis.
“That flexibility might prove useful in some circumstances,” said Mr. Sack.
A portfolio concentrated in short-term bills has some other advantages. It would allow Fed officials to argue they are no longer providing the economy with unconventional stimulus, something congressional Republicans criticized during and after the financial crisis.
Some Republicans told Mr. Powell at a hearing last month they were troubled the Fed might maintain a larger portfolio, a sign of the lingering disapproval of the central bank’s crisis-era interventions.
Finally, a portfolio with mostly shorter-maturity holdings would give the Fed another lever to pull should another recession hit. In that situation, it could shift the portfolio back into long-term securities to provide new stimulus, as it did in 2011 with a program called “Operation Twist.”
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