NEW YORK (Reuters) - The U.S. Federal Reserve pressed ahead with plans to shrink its $4.5-trillion portfolio on Wednesday, mapping out a very gradual approach to shedding assets that allows it to begin the tricky process as soon as September.
The U.S. central bank’s decision to revise a long-standing “policy normalization” plan came as somewhat of a surprise given a series of weak inflation readings risked delaying its march towards tighter policy. Its blueprint for halting current reinvestments by ever-larger increments of maturing Treasury- and mortgage-backed bonds came in at the low end of Wall Street estimates.
The Fed amassed the securities in three rounds of so-called quantitative easing, or QE, meant to stimulate U.S. investment and hiring in the wake of the 2007-2009 financial crisis and recession. The risk is that as the world’s largest holder of Treasuries begins to edge back from the market, borrowing costs could shoot higher - though that has not yet happened.
Policymakers, who also raised policy rates a notch as expected, did not specify when they would begin the bond trimming, though they are aiming for some time later this year.
“We could put this into effect relatively soon,” Fed Chair Janet Yellen said at a press conference in Washington, a comment that caused longer-dated Treasury yields to rise from low levels earlier in the trading day.
As it stands, the central bank tops up any bonds that mature to keep its balance sheet steady at its record high level.
According to the plan, the Fed would initially allow no more than $6 billion in Treasuries to run off per month, and will raise that “cap” each quarter by $6 billion over 12 months until it reaches $30 billion in maturing bonds per month.
For mortgage bonds, the Fed would start with $4 billion per month and raise it in quarterly steps of $4 billion until it reaches a $20-billion monthly limit.
Wall Street economists had been predicting the cap on Treasuries would fall roughly between $5-$15 billion per month, and on mortgage bonds $5-$10 billion, rising by increments of $5-$15 billion, according to research notes.
While the plan itself was seen as dovish, more aggressive was the fact the Fed wasted no time in laying it out.
“This does seem like a more hawkish statement: the Fed announcing an update to their reinvestment principles leaves September open to the start of balance sheet runoff,” said Gennadiy Goldberg, interest rate strategist at TD Securities, in New York. Fed policy meetings in October and December were seen as alternative options to begin the process.
In response to the Fed’s announcements, short-dated Treasury yields rose from earlier lows while longer-dated yields also rebounded. Mortgage-backed securities clung to earlier gains, with investors calling the plan modest.
It “is so mild and mechanical that it shouldn’t be an issue for the longer-dated Treasury or MBS markets,” said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin. “They stormed into the room with QE and are tiptoeing out almost unnoticed.”
Yellen said the initial caps were set at “relatively low levels” to guard against possible sharp rises in market yields. The caps would remain in place until the portfolio shrinks to a to-be-determined level “appreciably” below $4.5 trillion, she said, adding that decision will hinge in part on what the Fed learns as it sheds bonds.
The central bank added that while its main tool for managing monetary policy will remain short-term interest rates, it would be prepared to halt its bond-reductions or even add more assets to its portfolio should there be a “material deterioration in the economic outlook.”
Gene Tannuzzo, senior portfolio manager at Columbia Threadneedle, said future market volatility will probably force the Fed to adapt.
“It all sounds fine now when (stocks) are at all time highs and credit spreads are tight and volatility is low,” he said. “But I’d be shocked if, in 2020, there haven’t been some bumps along the way.”
Additional reporting by Ann Saphir, Richard Leong, Karen Brettel and Rodrigo Campos; Editing by Chizu Nomiyama