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.
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
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
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
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.
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.
is PIMCO’s global strategic advisor and a frequent contributor
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