Coming into today, the Federal Open Market Committee (FOMC) as a committee had written very little about its plans tonormalize the size of the Fed’s $4.5 trillion balance sheet. Investors havecrucial questions: Will the Fed phase out reinvestment in its portfolio ofU.S. Treasuries and mortgage-backed securities (MBS), or go cold turkey andcease reinvestment all at once? Also yet to be determined is the ultimatesize and composition that the Fed is aiming for in its balance sheet.
The Fed’slast 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 securitiesholdings in a gradual and predictable manner primarily by ceasing toreinvest repayments of principal on securities held in the SOMA [SystemOpen Market Account].
- The Committee expects to cease or commence phasing outreinvestments after it begins increasing the target range forthe federal funds rate; the timing will depend on how economicand financial conditions and the economic outlook evolve.
- The Committee currently does not anticipate selling agencymortgage-backed securities as part of the normalizationprocess, although limited sales might be warranted in thelonger run to reduce or eliminate residual holdings. The timingand pace of any sales would be communicated to the public inadvance.
The Committee intends that the Federal Reserve will, in thelonger run, hold no more securities than necessary to implementmonetary policy efficiently and effectively, and that it willhold primarily Treasury securities, thereby minimizing theeffect of Federal Reserve holdings on the allocation of creditacross sectors of the economy.
The Committee is prepared to adjust the details of its approachto policy normalization in light of economic and financialdevelopments.
This statement leaves out much more than it reveals, not becausethe Fed has a secret plan to unwind its balance sheet, but ratherbecause coming into the March 2017 FOMC meeting, the Fed as a committee had no plan! It just had the statement ofintentions and cautious caveats. In the years since, individualmembers of the FOMC have expressed opinions and personalpreferences – New York Fed President Bill Dudley is the most recentexample – but there has been no official update to the 2014statement.
Unwinding likely to affect markets
The way in which the Fed normalizes its balance sheet will haveimportant implications for markets and specifically for financialconditions. Unanswered questions include, how will the unwindingprocess proceed (passive roll-off or tapered glide path)? startingwhen? at what pace? over what time frame? to what destination?Needless to say, if (as Fed officials believe, and I agree) thethree asset purchase or quantitative easing (QE) programs the Fedundertook in the months and years following the global financialcrisis lowered the term premium on long-maturity U.S. Treasuriesand mortgages, then the unwinding of this portfolio likely will putupward pressure on term premia.
In theminutes from the March 2017 meeting, we learned two important new things about the FOMC’s plans forthe balance sheet. First, we learned that most participants thoughtthat “a change to the Committee’s reinvestment policy would likelybe appropriate later this year.” Second, we learned that“participants generally preferred to phase out [i.e., taper] orcease reinvestments of both Treasury securities and agencyMBS” once the process begins (italics mine).
What does this mean for markets? The challenge facing Fedpolicymakers is that since they believe that expanding the balancesheet via three QE programs lowered bond yields andespecially the term premium on long-dated Treasuries, their modelsare also telling them that unwinding these programs will increasebond yields. The problem is that they have little faith in theirmodels to tell them by how much. So they seem torn between apassive approach that would be easy to implement – stop reinvesting– and a process of actively managing the unwinding. This point isespecially relevant for the MBS market. Because of the embeddedprepayment option in MBS, the actual pace of prepayments is unknownby the Fed and will depend on the economy and the path of ratesitself. In short, a passive program will not be predictable, and apredictable program – at least for MBS – won’t be passive.
So the Fed today began to answer some but by no means allof the questions it needs to resolve before it begins to scale backthe size of its portfolio. But if the committee intends to commencethe process later this year, it still has a lot of work to do.
Richard Claridais PIMCO’s global strategic advisor and a frequent contributorto thePIMCO Blog.
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