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 Though it ended a stimulative asset-purchase program last October,
the Fed is still buying mortgage and Treasury bonds to replenish its
$4.5-trillion portfolio as holdings mature. The central bank has
said it will keep reinvesting until some time after it begins
raising interest rates later this year.
Asked publicly and privately about the longer-term strategy, Fed
policymakers say they are in no rush to shrink the portfolio,
suggesting they will seek to avoid a "cliff" - a disruptive end to
reinvestments that might come if bonds are simply allowed to run off
through maturity or prepayment.
Economic analysis shows that shifting the end of reinvestments by
several months in either direction would have "essentially no effect
on the economic outlook," San Francisco Fed President John Williams
told reporters last Friday.
"My view is this would happen organically," he added. But to avoid
confusing investors with too many changes at once, he said, the Fed
should give investors time to get used to rate increases before
allowing the balance sheet to shrink. "You want enough separation in
time just so that, once we get the (rate) normalization process
going ... then this would be a decision that would be of
second-order."
Six years of crisis-era purchases meant to boost economic growth
quintupled the size of the Fed's balance sheet. The Fed predicts it
will take until 2020 to shrink the portfolio back to normal.
The central bank can always sell bonds, but it said in September it
will rely primarily on run-off to reduce holdings in a "gradual and
predictable manner."
MANAGED DECLINE
St. Louis Fed President James Bullard told Reuters this year he
wants to manage the rate of decline, a strategy that many bond
investors expect. Simon Potter, the New York Fed official whose team
manages the portfolio, said last month the central bank had an
option to reduce the level of reinvestments gradually, rather than
ending them all at once.
More than $200 billion of the Fed's Treasuries are set to expire in
2016, after very little matured this year. Among its mortgage-backed
securities (MBS), which are harder to evaluate due to prepayments
and amortizations, analysts estimate up to $300 billion could run
off the balance sheet next year.
While some investors talk of a looming "balance sheet cliff," many
Fed officials are more focused on when and how aggressively to raise
interest rates, rather than on managing the reduction of holdings.
Simply allowing assets to roll off "is likely to be satisfactory,"
said Charles Evans, head of the Chicago Fed. "I think it's going to
be at some point after we are comfortable in our liftoff strategy."
Cleveland Fed President Loretta Mester told reporters last week that
"there's been no determination about what the appropriate timing
would be."
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According to a March survey by the New York Fed, primary dealers
expect the portfolio to shrink about six months after the Fed hikes
rates, or sometime in the first quarter of 2016.
But policymakers could delay that for fear of slowing the economy
given consumer confidence remains fragile and some Americans still
struggle to get loans. Before that, rate hikes could also be delayed
if the state of the economy called for it.
Donald Kohn, a former Fed vice president, predicted in a note to
Potomac Research clients that the Fed would keep reinvesting
proceeds from maturing bonds until it hikes rates to 1 percent or
more. That could be well into the second half of next year,
according to the Fed's March forecasts.
Once the balance sheet starts to shrink, some analysts are
predicting the Fed would keep reinvesting proceeds from half or even
two-thirds of the roughly $40 billion in bonds expected to naturally
run off each month, depending on the state of the economy.
"This means that the Fed will be a large and active participant in
the bond market for the next few years," said Roberto Perli, a
former Fed official who is now partner at research firm Cornerstone
Macro.
Reliable demand from the central bank has helped bond markets stay
near record highs, making it cheap for Americans to take on
mortgages and other loans. A 30-year fixed-rate mortgage remains low
at 3.9 percent, according to Bankrate.
The Fed is by far the top holder of agency mortgage bonds, with
about a third of the market at $1.7 trillion, said Andrew
Szczurowski, vice president and fund manager at Eaton Vance.
"The Fed has handcuffed itself and must be very careful when trying
to exit the market," he said, "because the last thing it wants is
for spreads to blow out on MBS and mortgage rates to rise
substantially."
(Reporting by Jonathan Spicer and Ann Saphir; Editing by Tomasz
Janowski)
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