Fed won’t reduce bond book this year, Yellen signals
US FEDERAL Reserve chair Janet Yellen set a relatively high hurdle for shrinking the central bank’s balance sheet, leading some analysts to conclude that such a move won’t occur this year.
She told the Senate Banking Committee on Tuesday that the Fed’s focus was on raising interest rates to keep the economy in balance, not on reducing its holdings of bonds.
Rates first had to reach sufficiently high levels before the Fed felt it had some room to cut them to offset a weakening economy. Only then would the central bank begin to shrink its $4.5 trillion (R58.7tn) balance sheet, she said.
“What we would like to do is to find a time when we judge that our need to provide substantial accommodation to the economy in the coming years is minimal,” she said.
The central bank also wanted to be sure “that the economy is on a solid course and the federal funds rate has reached levels where we have some ability to address weakness by cutting it”, she added.
Ward McCarthy, the chief financial economist for Jefferies LLC in New York, said this meant there would not be a move to start shrinking the balance sheet this year.
Policymakers expect to increase the Fed funds rate to 1.4 percent by the end of this year, according to the median of their projections released on December 14. That would still leave it below the 20-year average of 2.3 percent.
The timing and scope of any moves to reduce the Fed’s debt holdings could have big implications for the bond market and for the economy as a whole. That’s because, as Yellen herself noted, they would represent an effective tightening of monetary policy. “Allowing that process to take place,” Yellen said, “will show that the economy is doing well.”
The policy-setting Federal Open Market Committee (FOMC) has said it will continue to reinvest principal payments on the maturing bonds in its portfolio until “normalisation of the level of the federal funds rate is well under way”. The Fed chair said the reduction in the Fed’s bond portfolio would occur in a “gradual and orderly way”.
Yellen told the lawmakers on Tuesday that the FOMC would discuss that strategy “in the coming months” with the aim of providing investors with “some further guidance” about its intentions.
The central bank would want to telegraph its plans well in advance of their implementation, to avoid upsetting financial markets, Michael Feroli, the chief US economist at JPMorgan Chase in New York, said.
He expects policymakers to do that in the second half of this year. However, the process of halting reinvestments will not begin until the middle of next year, according to Feroli.
Yellen rejected recent suggestions by several Fed bank presidents that the central bank use its balance sheet as an active tool of monetary policy. Instead, the focus will remain on managing the Fed funds rate in response to changes in the economy.
The Fed chair also said the reduction in the Fed’s bond portfolio would occur in a “gradual and orderly way”. That’s similar to the strategy the central bank employed when it tapered its asset purchases in 2014, reducing them in set amounts at each policymaking meeting.
More than $600 billion (R7.8tn) in Treasury securities in the Fed’s portfolio are scheduled to mature this year and next, according to calculations by Bloomberg.
McCarthy said the next Fed chair might well take a more aggressive approach to reducing the balance sheet, although Feroli said it might be difficult to change the Fed’s strategy once it has been put into place and digested by the markets.
Yellen told lawmakers that she expects the central bank to eventually end up with “a balance sheet that’s substantially smaller than at the current time”.
“In addition, we would like our balance sheet to again be primarily Treasury securities,” she said. Besides Treasuries, the Fed portfolio also contains mortgage-backed debt and agency securities issued by Fannie Mae and Freddie Mac.