Coming into today, the Federal Open Market Committee (FOMC) as a committee had written very little about its plans to normalize the size of the Fed’s $4.5 trillion balance sheet. Investors have crucial questions: Will the Fed phase out reinvestment in its portfolio of U.S. Treasuries and mortgage-backed securities (MBS), or go cold turkey and cease reinvestment all at once? Also yet to be determined is the ultimate size and composition that the Fed is aiming for in its balance sheet.
The Fed’s last statement on its normalization plans was published in September 2014. It reads, in part, as follows:
The Committee intends to reduce the Federal Reserve’s securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA [System Open Market Account].
- The Committee expects to cease or commence phasing out reinvestments after it begins increasing the target range for the federal funds rate; the timing will depend on how economic and financial conditions and the economic outlook evolve.
- The Committee currently does not anticipate selling agency mortgage-backed securities as part of the normalization process, although limited sales might be warranted in the longer run to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public in advance.
The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy.
The Committee is prepared to adjust the details of its approach to policy normalization in light of economic and financial developments.
This statement leaves out much more than it reveals, not because the Fed has a secret plan to unwind its balance sheet, but rather because coming into the March 2017 FOMC meeting, the Fed as a committee had no plan! It just had the statement of intentions and cautious caveats. In the years since, individual members of the FOMC have expressed opinions and personal preferences – New York Fed President Bill Dudley is the most recent example – but there has been no official update to the 2014 statement.
Unwinding likely to affect markets
The way in which the Fed normalizes its balance sheet will have important implications for markets and specifically for financial conditions. Unanswered questions include, how will the unwinding process proceed (passive roll-off or tapered glide path)? starting when? at what pace? over what time frame? to what destination? Needless to say, if (as Fed officials believe, and I agree) the three asset purchase or quantitative easing (QE) programs the Fed undertook in the months and years following the global financial crisis lowered the term premium on long-maturity U.S. Treasuries and mortgages, then the unwinding of this portfolio likely will put upward pressure on term premia.
In the minutes from the March 2017 meeting, we learned two important new things about the FOMC’s plans for the balance sheet. First, we learned that most participants thought that “a change to the Committee’s reinvestment policy would likely be appropriate later this year.” Second, we learned that “participants generally preferred to phase out [i.e., taper] or cease reinvestments of both Treasury securities and agency MBS” once the process begins (italics mine).
What does this mean for markets? The challenge facing Fed policymakers is that since they believe that expanding the balance sheet via three QE programs lowered bond yields and especially the term premium on long-dated Treasuries, their models are also telling them that unwinding these programs will increase bond yields. The problem is that they have little faith in their models to tell them by how much. So they seem torn between a passive approach that would be easy to implement – stop reinvesting – and a process of actively managing the unwinding. This point is especially relevant for the MBS market. Because of the embedded prepayment option in MBS, the actual pace of prepayments is unknown by the Fed and will depend on the economy and the path of rates itself. In short, a passive program will not be predictable, and a predictable program – at least for MBS – won’t be passive.
So the Fed today began to answer some but by no means all of the questions it needs to resolve before it begins to scale back the size of its portfolio. But if the committee intends to commence the process later this year, it still has a lot of work to do.
Richard Clarida is PIMCO’s global strategic advisor and a frequent contributor to the PIMCO Blog.
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