Published March 08, 2013
The Federal Reserve is considering jettisoning a plan to eventually sell off the massive haul of bonds it is now buying, a politically defensive strategy that would have the added benefit of supporting the economy for years to come.
In what would be a revision of their blueprint for the eventual tightening of monetary policy, Fed officials have said they could simply allow the trillions of dollars in securities they have bought through three rounds of quantitative easing to mature.
Fed Chairman Ben Bernanke and other officials have said a decision not to sell the mortgage and Treasury bonds would only add about a year to the process of returning the central bank's balance sheet to a more normal size of around $1 trillion, probably around 2020. It is worth some $3 trillion now, and could swell to near $4 trillion by year end.
While a new "exit strategy" is not likely to emerge from the Fed's next meeting on March 19-20, officials plan to review the blueprint soon because it has not been updated since mid-2011.
Under the existing plan, the Fed would commence asset sales at some point after policymakers begin to raise interest rates.
But things have changed since the plan was put in place.
Not only has the central bank's balance sheet grown in value, but the average duration on the bonds has risen by 3 years to about 10 years. That means the Fed could suffer big losses on its portfolio later this decade if it sells assets when interest rates climb.
The central bank regularly sends the bulk of its earnings to the Treasury. While it has never missed a payment, some Fed policymakers fear portfolio losses in the years ahead would expose it to attacks from critics in Congress and could prompt lawmakers to clamp down on their freedom to pursue monetary policy as they see fit.
If they do not sell the bonds, they will not realize a loss.
A bigger concern than politics, however, may be the U.S. economy's slow recovery from recession and its only tepid response to the most accommodative monetary policies ever.
Hanging on to the bonds would keep downward pressure on longer-term borrowing costs, encouraging economic growth even after the Fed starts to raise overnight rates from near zero, where they have been since 2008. The strategy would also avoid disrupting financial markets with possibly huge sales.
"That's a double barrel hit and that would be way too much," said John Silvia, the chief economist at Wells Fargo Securities LLC. "The market can deal with assets rolling off," he said, referring to bonds maturing and not being replaced with new purchases, but it "would have a tough time" judging the Fed's sales.
Of course, the Fed is already disrupting the market with its outsized balance sheet. Not selling the assets would mean at least another year in that uncomfortable position, when the economy may not need that support.
As part of its efforts to spur the economy after the deepest recession since the Great Depression, the central bank is currently buying $85 billion in bonds per month. It has said it intends to do so until the troubled labor market improves.
Through the strategy announced in June 2011, when the time is right the Fed plans to stop reinvesting principal on the securities and then start to drain the massive amounts of cash it has injected into the banking system.
Later, it would raise the benchmark federal funds rate, and finally start selling the remaining bonds over a five-year span to shrink the balance sheet down to size.
But in congressional testimony last week, Bernanke said the Fed will have to review that strategy sometime soon and noted that it could simply hold the securities to maturity, which he said would add perhaps an extra year to the whole process.
Holding the securities could even be an alternative to asset purchases that would give the economy a bit of a lift, he said.
In a recent speech, Fed Governor Jerome Powell argued that simply allowing assets to run off the balance sheet would address growing concerns that selling older-issue mortgage-backed securities could destabilize markets.
Powell added that "it would also smooth remittances," referring to the Fed's payments to the Treasury.
Central bank researchers warned in January that the Fed could miss payments to the Treasury for up to four years, and that the loss could spike as high as $125 billion in 2019, under a scenario in which securities are sold and rates were higher than expected.
Making things worse, at least politically, the losses could come at a time when the Fed is paying banks higher interest on excess reserves. That could attract unwelcome scrutiny from U.S. lawmakers, some of whom have sharply criticized the bond buying.
"The Fed's official view is they will not let politics influence their view. My view is, that may be a little bit naive," said James Hamilton, economics professor at University of California at San Diego and a research associate of the National Bureau of Economic Research.
"One way to avoid that political side of things would be just to never realize those losses."
A recent paper co-authored by Hamilton suggests it would take about two years longer - until 2020 or so - to normalize the balance sheet if the Fed were to hang on to the securities.
A decision not to sell bonds, especially if stated forcefully by the Fed, would be stimulative both now and in the future because longer-term expectations about how many bonds will be in the market can effect the current pricing.
Theoretically, it could also allow the Fed to curb its current bond buying earlier than planned, or raise rates sooner.
Still, there will likely be resistance to the idea from the more hawkish wing of the Fed's policymakers who are not comfortable with such a large balance sheet.
Charles Plosser, head of the Philadelphia Federal Reserve, said winding down the balance sheet should depend on market conditions at the time, and on how effectively the central bank can control the flow of private bank reserves back into the economy.
"We don't know the answer to that, so I think it's hard to pre-commit to saying we won't sell assets, even in the face of rising inflation rates," Plosser told reporters on Wednesday. "I would be nervous about that effort.
Once the Fed starts to lift short-term rates, it might then be wise to sell some assets if economic growth is strong and bond markets seem able to absorb even higher longer-term rates.
The Fed might be smarter to hang on to the assets, however, if economic growth starts to slow and longer-term rates are already rising significantly.
Michael Feroli, chief U.S. economist at JPMorgan, said the benefits of a "no asset sale" policy are compelling enough that there is a good chance the Fed will adopt it.
"I'm not sure when we will see a new exit strategy," he added, "but I wouldn't be surprised to see one by June."