By Nick Timiraos
The Federal Reserve is likely to announce Wednesday the start of
its plan to slowly and passively pare its massive bondholdings.
Here are answers to three of the most commonly asked questions from
our readers about how it works.
Q: OK, I know the Fed accumulated the holdings by buying bonds.
And I've read that it will shrink the portfolio by letting limited
amounts of them mature, which means it will receive principal
payments from the issuers. So what will the Fed do with that
money?
A: The Fed essentially created money out of thin air to buy the
bonds. Now, it will destroy the money the same way.
The central bank has been reinvesting the proceeds from maturing
Treasurys and mortgage-backed securities to keep its portfolio
steady at around $4.5 trillion. It will soon begin to allow small
amounts of these bonds to mature without any reinvestment.
To explain what it does with the money it helps to recall how it
bought the bonds in the first place. When private investors buy
bonds, they use cash, borrow funds or sell assets to raise the
money to make that purchase.
The Fed is different. It doesn't have to do any of those things
because it has the power to electronically credit money to the bank
accounts of bond dealers who sell mortgage-backed securities or
Treasurys. The Fed gets the securities, and the seller sees its
account increase by the same amount as the securities' value. The
Fed isn't literally printing paper currency to do this, but it is
creating funds electronically that weren't in the financial system
before.
This process is about to go into reverse. Instead of reinvesting
the proceeds of maturing bonds, the Fed will erase them
electronically. It won't be destroying any paper currency, but the
money essentially vanishes from the financial system.
The New York Fed provides a detailed breakdown of the accounting
on its Liberty Street Economics blog.
The Fed plans to move gradually. For the first quarter --
probably to begin in October -- it will allow $6 billion in
Treasurys and $4 billion in mortgage bonds to roll off every month.
Anything beyond those limits still will be reinvested. Every
quarter, those amounts will increase until after a year, when the
Fed will allow up to $30 billion in Treasurys and $20 billion in
mortgages to expire without any reinvestment.
One important caveat: The Fed isn't going to sell any bonds.
Q: Why is the Fed doing this now?
A: First, the economy is on stronger footing. The Fed has raised
short-term interest rates four times in the last two years, and
with borrowing costs comfortably above zero, it is ready to unwind
the last, big piece of its unprecedented response to the 2008
financial crisis.
Second, the Fed's large holdings have become a political
liability, leaving critics sour over the experimental crisis-era
rescue efforts. Some Republican lawmakers didn't like that the
Fed's measures to keep interest rates low helped reduce the size of
budget deficits under President Barack Obama. Other critics say the
Fed's purchases of mortgage-backed securities to support the
housing market were a form of fiscal policy that would have been
better left to lawmakers.
Third, starting the process now also removes uncertainty for
financial markets about what the Fed plans to do with its balance
sheet, particularly given another source of uncertainty -- a
looming leadership reshuffle at the Fed. Within the next year,
President Donald Trump will have a chance to name five of the seven
members of the Fed's board, including its chairman and vice
chairman. By agreeing to a plan now -- and doing so unanimously --
the Fed has put in place a process that could be harder for its
future leaders to change.
Q: If the bond-buying programs are assumed to have been so
stimulative for the economy on the way in, why haven't markets
reacted more this summer to the coming end of bond
reinvestments?
A: In 2013, Fed officials' public comments about plans to slow
down bond purchases triggered a sharp market reaction known as the
taper tantrum. That hasn't happened so far this time around. It
could be a combination of luck, timing and skill.
Since the Fed stopped adding to its balance sheet, the European
Central Bank has launched its own asset-purchase program and the
Bank of Japan is also buying assets. It's possible markets won't
react to what's happening until the ECB starts to dial down its
purchases.
Moreover, the Fed has unveiled a very gradual approach. It never
fully stops reinvestments, and it will take about a year for the
Fed to ramp up the process of shrinking its holdings. Richard
Clarida, an economist at Pacific Investment Management Co., or
Pimco, compares the pace to a diet that calls for eating two
desserts a day instead of three.
Third, the Fed has been more precise in communicating its plans
this time. During the taper tantrum, markets mistakenly inferred
the Fed's decision to slow down its asset purchases also meant it
was rethinking the path of interest-rate increases. This time, the
Fed has made clear that its decision to shrink the balance sheet
doesn't imply any desire to change its rate-setting plans.
Finally, some of the benefit of the Fed's bond-buying programs
was psychological, the equivalent of "shock and awe" for finance.
The world's leading central bank showed markets that even though it
had already cut interest rates to near zero, it had an array of
stimulus tools ready to deploy should the economy require it,
including the bond buying sometimes called quantitative easing, or
QE. "A lot of the benefit was psychological, and people are not now
feeling that this is QE in reverse," said Lou Crandall, chief
economist of Wrightson ICAP.
The asset-buying programs also may have provided a bigger boost
because they helped repair credit markets that had frozen. Now that
markets are working again, reversing the program might not have as
great an effect.
Write to Nick Timiraos at nick.timiraos@wsj.com
(END) Dow Jones Newswires
September 19, 2017 13:15 ET (17:15 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.