Fed Officials Weigh Earlier-than-Expected End to Bond Portfolio Runoff
Next week’s meeting could yield more clues
Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.
Officials are still resolving details of their strategy and how to communicate it to the public, according to their recent public comments and interviews. With interest rate increases on hold for now, planning for the bond portfolio could take center stage at a two-day policy meeting of the central bank’s Federal Open Market Committee next week.
“A lot of the heavy lifting has been done,” said Kansas City Fed President Esther George in a Jan. 15 interview. “We’re waiting for the committee to be satisfied that they have reached sufficient understanding of what all the moving pieces are.”
The Fed began gradually shrinking its mortgage and Treasurys portfolio in 2017 by allowing securities to mature without reinvesting the proceeds into other assets. At the time officials said the slow unwind would fade into the background—the equivalent of watching paint dry.
Fed officials led markets to expect the process would take several years to play out. When the runoff began in October 2017, various officials estimated the portfolio—then around $4.5 trillion—could shrink to anywhere between $1.5 trillion and $3 trillion. New York Fed President John Williams said in April 2017, when he was the San Francisco Fed’s president, that runoff could last five years.
“In about three or four years, we’ll be down to a new normal,” said Fed Chairman Jerome Powell at his Senate confirmation hearing in Nov. 2017.
The latest discussions indicate the runoff could end much sooner.
The shrinking portfolio faced new scrutiny last month after some market commentators and President Trump blamed it for increasing market volatility. While many Fed officials don’t see much evidence to support those claims, the balance sheet is nevertheless getting increased attention inside the central bank.
Some officials have contemplated whether Mr. Powell or other top officials, short of announcing a complete road map for when the portfolio wind-down would end, could provide an update.
As officials reach agreement on their plans, “we may be able to say upfront, ‘Hey, the destination is going to be ‘X,’” said Minneapolis Fed President Neel Kashkari in a Jan. 17 interview. “Or we might say, ‘Hey, this is the plan [for how] we’re going to go to explore where that destination is.’”
Mr. Powell will hold a press conference after next week’s meeting. Whether he provides such a road map will depend on the progress of discussions at the meeting. Mr. Powell said this month he doesn’t think the Fed’s portfolio changes are a major culprit in recent volatility but that the central bank would change its drawdown, if officials came to a different conclusion.
The Fed’s decision about the size of its portfolio is being driven by a technical debate inside the central bank about reserves in the banking system, not over whether officials want to provide more or less stimulus to the economy.
Reserves are the funds banks keep on deposit with the Fed. When the Fed expanded its portfolio of bondholdings during and after the financial crisis, it expanded the amount of reserves in the financial system, pumping banks with money as it bought bonds. The banks in turn kept the new money on deposit with the central bank.
Initially after the crisis, some Fed officials wanted to wind down these reserves to precrisis levels, which meant shrinking the bond portfolio dramatically. Keeping reserves scarce would help them control interest rates as rates rose from zero, the thinking went.
Over time many officials have grown more confident they can manage interest rates even with an abundance of reserves. Some officials believe that holding a large buffer of reserves might even help minimize volatility in short-term money markets. If it keeps more reserves in the banking system, in turn, the Fed can keep a larger portfolio of securities.
The Fed has never said what size portfolio it wants, but a survey of financial institutions by the New York Fed provides some clues about where it could end up. The survey in December said market participants thought reserves would stabilize at $1 trillion in a year’s time. That compares to $1.7 trillion last week and $2.8 trillion in 2014. At that rate, the Fed’s asset portfolio would shrink to $3.5 trillion, larger than previous estimates of $1.5 trillion to $3 trillion. It is around $4 trillion now.
Lorie Logan, one of the top officials responsible for managing the portfolio and an executive at the New York Fed, said in a speech last May she saw “virtually no chance of going back to the precrisis balance sheet size.” She said, “The conversation is really about the relative amount of reserves.”
The idea that the Fed won’t return to its precrisis balance sheet size isn’t well appreciated by some stock investors, creating one potential source of market confusion, said Tom Porcelli, chief U.S. economist at RBC Capital Markets. “Equity investors think the runoff is going to continue in perpetuity,” he said.
Fed officials have often said they are moving toward a portfolio primarily of Treasurys, though it could take many years for its holdings of mortgage-backed securities to decline. It held more than $1.6 trillion worth of mortgage securities last week.
Minutes of the Fed’s last meeting also suggested officials want over time to move the portfolio toward more short-term Treasury securities. Now it holds more than $2 trillion in Treasury notes and bonds and no short-term bills.
Former Fed Chairman Ben Bernanke often argued that it was the maturity and risk-profile of the Fed’s holdings, not the overall size of its reserves or securities portfolio, that determined how much it stimulated markets and the economy.
A portfolio with riskier securities and long-term holdings, he said, was stimulative, because it drove down long-term interest rates and drove investors, households and businesses into more risk-taking that generated economic activity.
Viewed from that perspective, a Fed move toward a portfolio of mostly short-term Treasury securities, no matter the size, would reduce some fuel from markets and the economy.