The Fed is Ending its Crisis-Era Support | Zions Bank Community

The Federal Reserve announced that it would be ending its crises-era support and begin to gradually reduce its massive balance sheet.

Zions Bank Sep 22, 2017

Following its two-day meeting on Wednesday, the Federal Reserve announced that it would be ending its crises-era support and begin to gradually reduce its massive balance sheet in October. This widely-anticipated move comes nearly 10 years after the central bank took the unprecedented steps of buying large quantities of U.S. treasuries and mortgage-backed securities in order to support the economy.

Also known as quantitative easing, these large purchases had the effect of ballooning the Fed’s balance sheet from roughly $800 billion in 2007 to close to $4.5 trillion today. Now that the Fed sees a strong labor market and growing economy, it seeks to slowly withdraw its support and shrink the size of its balance sheet

How We Got Here

The Federal Reserve is tasked with maximizing employment, promoting stable prices, and ensuring moderate long-term interest rates. It does this by influencing short-term interest rates and managing the availability of credit in the economy. The Fed directs short-term interest rates by setting a target range for the Federal Funds Rate, which is the rate banks borrow from one another overnight. When the Fed seeks to support the economy, it lowers the rate in order to encourage borrowing, and when the Fed wants to slow the economy, it raises the rate to make borrowing more expensive.

Following the Great Recession, the U.S. economy was extremely fragile and needed support. However, after decreasing the Federal Funds Rate to near-zero the Fed had to use a different tool to support economic growth and credit availability. That’s when it took the extraordinary step of buying U.S. treasuries and mortgage backed securities. By buying these types of assets, the Fed was able to lower longer-term interest rates in order to encourage people to buy homes, cars and for business to invest in projects. While the Fed’s effectiveness in supporting the economy has been debated, what did happen was that the Fed was left holding much larger quantities of U.S. treasuries and mortgage-backed securities than it ever had before.

The Plan to Unwind

Currently, the Federal Reserve reinvests all the proceeds from its maturing securities into new ones, which maintains the size of its balance sheet. However, under the new plan, the Fed will gradually reduce the amount it reinvests each month, thus shrinking the overall size of its balance sheet. The Fed wants this process to be as boring and automatic as possible, as to not disrupt or distract markets. The process will take place over a number of years, and it is unclear when or at what size the Fed will decide to cease this practice. It is generally believed that the balance sheet of the future will be somewhere between pre-crises levels and the current level.

The Consequences

Never before has a central bank attempted to unwind a portfolio of this size, and its consequences are unknown. The Fed has been extremely careful about messaging their intent to act, and sticking to that message. Employing this messaging strategy gives the market time to process the plan and react in a controlled manner. In 2013, then-Fed Chairman Ben Bernanke’s announcement to reduce the balance sheet was met with severe swings in the bond market – an event that has been come to be known as the “taper tantrum”. Looking at the yield on the U.S. 10-year since the Fed’s recent plan announcement in June vs what happened in 2013, after Bernanke’s comments, it seems as if the Fed has done a better job of messaging to the market.

Bond Markets

Many economists and market participants have been concerned about the reaction in the bond market following the Fed’s withdrawal of support. By purchasing U.S. treasuries and mortgage-backed securities on a rolling basis, the Fed has been supporting bond prices and keeping yields down (bond prices and yields move inversely). This has kept things like car loans and mortgage rates low. However, it is reasonable to believe that the cessation of these purchases could cause prices to drop and yields to rise. Thus, making it more expensive to borrow for a house or for companies to raise money for a new project. While this may happen as the Fed’s support gradually lessons, it hasn’t happened yet.

There is reason to believe that the effect won’t be as large as some anticipate. First, the U.S. bond market may be supported by international money searching for safe assets and good yield. This is because U.S. treasuries are considered some of the safest in the world and the U.S. economy is performing relatively better than many of its international counterparts. Currently, the yields on the U.K., Japanese, German, and Spanish 10-year bonds are all lower than the U.S., and if this continues, it will encourage international investors to buy U.S. bonds, which should, in-turn, put downward pressure on yields.

Secondly, the U.S treasury and mortgage-backed securities markets are very, very large. In the first months of the Fed’s plan to unwind, it plans to reduce its purchases of U.S. treasuries by $6 billion and agency securities by $4 billion (includes mortgage-backed securities) per month. While this may seem like a large number, if you consider that the daily trading volume of the U.S. treasury market is roughly $500 billion and mortgage-backed security market $200 billion, what the Fed plans to do is merely a drop-in-the-bucket.

Stock Market

The stock market continues to hit all-time highs, and hasn’t been tripped-up by the Fed’s plan to reduce its bond holdings. There are many who argue that the huge run-up in the stock market has been a product of the Fed unnaturally holding down the yields of bonds and making the stock market more attractive to investors. If bond yields were to rise drastically, it could pull investors out of the stock market and into the bond market. This hasn’t been a problem yet, and the Dow Jones Industrial Average hit an all-time high immediately following the Fed’s Wednesday announcement.

The Long Run

The long-run implications of the Fed’s decision to shrink its balance sheet are unknown. The Fed is embarking on a path that has never been taken before and its actions are being closely watched by other central banks around the world. Depending on what the results are, other central banks will likely proceed in a similar fashion or plot a somewhat different course when they decide to reduce their balance sheets. It is reasonable to believe that the Fed’s slow withdrawal from its long-term asset purchases will push interest rates up, but there is also reason to believe that other factors may keep this rise in-check.

Either way, interest rates should naturally rise as the economy improves and the Fed continues to hike short-term rates. What may matter more, is the success of policies in Washington, DC. Tax and healthcare reform, along with any infrastructure plans, will likely have a greater effect on the bond and stock markets than the Fed’s reduction in asset purchases.

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