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.
Write to Nick Timiraos at nick.timiraos@wsj.com
(END) Dow Jones Newswires
January 11, 2019 05:44 ET (10:44 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.