Yellen Sets High Hurdle for Reducing Fed's Massive Bond Holdings

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, and not on reducing its holdings of bonds.

Rates first need to reach sufficiently high levels that the Fed feels it has some room to cut them to offset a weakening economy. Only then would the central bank begin to shrink its $4.5 trillion 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 wants 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, chief financial economist for Jefferies LLC in New York, said that this meant no move to start shrinking the balance sheet in 2017.

Policy makers expect to increase the fed funds rate to 1.4 percent by the end of 2017, according to the median of their projections released on Dec. 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 has said it will continue to reinvest principal payments on the maturing bonds in its portfolio until “normalization of the level of the federal funds rate is well underway.”

Further Guidance

Yellen told the lawmakers Tuesday that the FOMC will discuss that strategy “in the coming months” with the aim of providing investors with “some further guidance” about its intentions.

The central bank will want to telegraph its plans well advance of their implementation so as to avoid upsetting financial markets, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York.

He expects policy makers to do that in the second half of this year. The process of halting reinvestments though won’t 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 that the reduction in the Fed’s bond portfolio would occur in a “gradual and orderly way.”

Gradual Taper

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 policy-making meeting.

More than $600 billion in Treasury securities in the Fed’s portfolio are scheduled to mature this year and next, according to calculations by Bloomberg.

Yellen’s four-year term as Fed chair expires on Feb. 3, 2018, and she repeated that she has no plans to leave the central bank before then.

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.

There’s a limit to how far the balance sheet can be reduced, however. At a minimum, it needs to be big enough to cover the roughly $1.5 trillion in currency now in circulation, which is increasing every year.

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Rob Myers
By Rob Myers 02/15/2017 04:23:00