What could lead the Fed to a balance sheet reduction “plan B”


The U.S. Federal Reserve Building on Constitution Avenue is pictured in Washington, U.S., March 19, 2019. REUTERS/Leah Millis

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Feb 17 (Reuters) – Amid a strong U.S. housing market, low interest rates and skyrocketing inflation, the Federal Reserve has added to its bond portfolio to date, prompting no not just let the securities expire over time, but to expand plans to start selling them directly.

Selling is unlikely to be included at the start of balance sheet ‘normalization’ plans that officials are expected to approve in the coming months, a process that will run alongside interest rate hikes aimed at calming inflation .

But if the fight against inflation doesn’t succeed fast enough, some Fed officials want a “plan B” that would venture into new territory and use sales of mortgage-backed securities (MBS) to boost inflation. mortgage rates, one of the main channels the US central bank can use to reduce inflation because it keeps house prices low and leaves less room in household budgets for other spending.

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Fed officials discussed the possibility of MBS sales at their Jan. 25-26 policy meeting, with “many attendees” saying it might be appropriate “at some point in the future,” the Fed showed on Wednesday. minutes of the meeting. Read more

Home borrowing costs are already rising rapidly, with the average contract rate for a 30-year fixed-rate mortgage exceeding 4% this month for the first time since 2019, according to the Mortgage Bankers Association. Even before the Fed’s first rate hike – which is expected to take place next month – or the first bond in its portfolio matures without replacement, this key consumer interest rate has jumped a full percentage point in less than six months.

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Still, the Fed’s $2.7 trillion MBS stock acts as an anchor on interest rates in that market, preventing them from getting even higher, and some officials say the footprint of the central bank may have to shrink faster than it would through natural “trickle-down”. This process of moving securities off the balance sheet as they mature is particularly slow and unpredictable for MBS and can take longer when rates rise.

“I’m still keeping that option open in scenarios where inflation doesn’t moderate as we hoped and we’re going to have to toughen up a bit,” St. Louis Fed Chairman James Bullard told Reuters early. February.

And speaking on CNBC this week, Bullard said he supports starting the balance sheet reduction in the second quarter of this year through the passive approach and then using asset sales as “Plan B.” if necessary to “pick up the pace”.


Investors want to know how the Fed will unwind more than $8 trillion in MBS and Treasuries – a portfolio that has doubled during the coronavirus pandemic as the central bank clawed back assets to stabilize markets and the economy .

Bond purchases have long been a contentious aspect of monetary policy, in part because of lingering questions around exit strategy, with some critics arguing that selling securities when interest rates rise can waste money. money at the central bank. Bond prices fall when interest rates rise and vice versa.

The Fed avoided bond sales in the last balance sheet reduction between 2017 and 2019. Policymakers want to rely primarily on the liquidation strategy this time around as well, according to guidance released last month.

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But some Fed officials and analysts say the passive approach could backfire. Bullard and Kansas City Fed President Esther George are among those who flagged high inflation as a concern.

Selling may also be needed to help the Fed meet its long-term goal of shifting to a portfolio of mostly Treasury securities, Cleveland Fed Chair Loretta Mester said recently.

Part of the problem is the Fed’s mortgage holdings, which are expected to come off its balance sheet more slowly than its Treasury holdings once the portfolio reduction begins.

For example, about $2.5 trillion of the Fed’s Treasury holdings have short maturities and would mature within the next three years, according to analysis by the Fixed Income Team at the Schwab Center for Financial Research. But it’s unclear exactly how long it will take for the Fed’s mortgage holdings to come off the balance sheet, analysts said.

Portions of securities are prepaid when people sell their homes or refinance their loans, causing them to pay off their mortgages before the original maturity date. And it usually takes time for MBS to come off the balance sheet naturally.

Between October 2017 and September 2017, the Fed capped monthly cuts at $50 billion, but the actual drop was usually much less than that. Policymakers want to move faster this time, but worry that the Fed’s mortgage holdings will prove “sticky,” especially when mortgage rates rise.

That’s because fewer people refinance their mortgages when rates rise, slowing the prepayment rate on loans, said Kathy Jones, chief fixed-income strategist for the Schwab Center for Financial Research.

In fact, it may already be. MBA data shows refinance application volumes are at a two-year low and their share of all mortgage applications is the lowest since July 2019.

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Fed officials are currently calculating numbers on how long it will take for mortgage holdings to be depleted from the portfolio and no decision has been made, Mester said.

But the Fed may want to address the possibility of asset sales early on when it begins to provide guidance on its plans for the balance sheet, Jones said.

“They’re going to want to answer the question one way or another,” Jones said.

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Reporting by Jonnelle Marte and Howard Schneider; Editing by Dan Burns and Paul Simao

Our standards: The Thomson Reuters Trust Principles.


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