In the wake of the financial crisis a decade ago, the Federal Reserve purchased $4.5 trillion worth of intermediate- and long-term bonds as it sought to boost the economy by making it less expensive to borrow for everyone from the government and businesses to homeowners.
Beginning in late 2008, the Fed began large-scale purchases of assets such as U.S. treasuries and government-supported mortgage-backed securities (MBS) to stave off a complete collapse of the financial system.
With the financial crisis and deep recession years behind us, the Fed now is poised to trim back on its investments and unwind its balance sheet.
Nearly three years ago, Fed Chair Janet Yellen announced the end of the bond-buying program, the Fed’s balance sheet had reached $4.48 trillion. By reinvesting principal payments and maturing securities, the balance sheet has remained at or about $4.5 trillion since. According to weekly data published by the Fed, its balance sheet consists of $2.5 trillion in treasuries and $1.8 trillion in mortgage-backed securities.
At the Federal Reserve June meeting, committee members stated that they plan to begin tapering by letting $6 billion a month in maturing Treasuries run off, which will slowly increase over the coming months.
“For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month,” the Fed said.
With regards to its agency debt and Mortgage-Backed Securities (MBS), the Fed laid out a similar plan where it will begin tapering $4 billion a month until it reaches $20 billion.
Moreover, the Fed said the long-run plan is to keep the balance sheet “appreciably below that seen in recent years but larger than before the financial crisis.”
By letting the bonds “run off” rather than actually selling the bonds, the Fed is minimizing the impact on the market.
Economists are keeping a watchful eye on the Fed and its plan to raise rates.
A recent poll of more than 100 economists found that they forecast the fed funds rate to climb to a range of 1.25 percent to 1.50 percent by the end of this year.
Ethan Harris, head of global economics at Bank of America Merrill Lynch, told Reuters there is some concern that the Fed may be getting ahead of itself.
“We don’t agree with the idea that the Fed seems to be selling that balance sheet shrinkage is something we should not be focused on, and it will simply occur in the background,” Harris said. “In a sense, they are setting aside one of their policy tools on auto-pilot. I don’t think they should be doing that.”
Economists and the Fed alike will be keeping a close eye on inflation and the economy, forecast by economists polled by Reuters to grow at an annualized rate of 2.2 percent to 2.5 percent each quarter to the end of 2018.
During a recent Senate committee hearing, Fed Chair Janet Yellen said it would be “quite challenging” for the economy to grow at the 3 percent target set by the Trump administration.
Bob Rice, chief investment strategist at Tangent Capital, admitted the task at hand for the Fed is great.
“There are chances for unexpected surprises, because there’s no telling what it will do to mortgage rates, and you will see a return of market volatility,” he said.
The unwinding could be particularly hard on the mortgage market, considering the Fed currently owns about 20 percent of the mortgage-backed securities market.
“We believe the Fed’s unwinding will likely have a bigger negative impact on mortgage-backed securities,” said Rick Keller, chairman of First Foundation.
Economists are not unanimous in their opinions, with some less certain the market dips will be just that.
The unwinding “is a market mover and an economic mover,” said Leon LaBrecque, managing partner and chief executive of LJPR Financial Advisors, which manages $707 million in client assets.
“As the Fed’s balance sheet unwinds, the cheap money dries up and companies will have to do more than the riskless share buy-backs,” he told Investment News. “It’s silly to think the unloading of trillions worth of bonds will have no effect.”