Fed Officials Ready to Start Portfolio Wind Down Within Months

By Nick Timiraos Features Dow Jones Newswires

WASHINGTON-Federal Reserve officials in June readied plans to start slowly shrinking the central bank's large portfolio of bonds and other assets in the next few months.

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Officials debated exactly when they should launch those plans, with several arguing the Fed had sufficiently prepared markets to go soon, while others suggested waiting for more proof that inflation would pick up, according to minutes of the central bank's June meeting released Wednesday.

Several Fed officials "preferred to announce a start to the process within a couple of months" in part because the Fed's "communications had helped prepare the public for such a step," the minutes said. Others urged more patience, with some suggesting "that a near-term change to reinvestment policy could be misinterpreted as signifying that the committee had shifted toward a less gradual approach to overall policy normalization."

Some officials have indicated since the meeting they would start the process as soon as September, while deferring any more rate increases until December.

The debate over the future policy path has been complicated by two puzzles for the Fed: Inflation has weakened, justifying some officials' call for a slower pace of rate increases, but financial conditions have eased, giving resolve to those who support steadily increasing rates.

Officials raised rates to a range between 1% and 1.25% at the June meeting, their third quarter-point rate increase in as many quarters, and they penciled in one more increase this year. They also reached consensus on how they will gradually reduce their $4.5 trillion asset portfolio, also known as their balance sheet, which could lead long-term rates to rise.

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Because the Fed is prepared to gradually shrink those holdings in a predictable manner, officials last month said they expected initiating those plans would have a limited impact on markets, according to the account published Wednesday.

The next Fed policy meeting is July 25-26. Fed Chairwoman Janet Yellen will have an opportunity to elaborate publicly on her outlook when she testifies before Congress next week to deliver the central bank's semiannual monetary policy report.

The central bank's discussion around the balance sheet picked up this year because officials have grown more comfortable with the economic outlook. Officials stopped adding to the balance sheet in 2014, but they have been reinvesting the proceeds of maturing assets to keep their holdings steady.

The Fed said last month when it starts allowing the holdings to decline, it will do so gradually by allowing a small amount of bonds to mature every month without any reinvestment. It would start by allowing up to $6 billion in Treasury securities and $4 billion in mortgage bonds to roll off without reinvestment, and let those amounts rise each quarter, essentially setting a speed limit for the wind-down.

The limits would ultimately rise to a maximum of $30 billion a month for Treasurys and $20 billion a month for mortgage-backed securities. Fed officials want the balance sheet wind down to run quietly in the background, meaning they are unlikely to adjust it from one meeting to the next barring a shock to the economy.

Officials raised rates last month despite some concern over declines in inflation gauges that they have largely attributed to one-off factors such as big discounts on wireless phone plans. The Fed's preferred inflation gauge, the price index for personal-consumption expenditures, briefly surpassed the Fed's annual 2% target in February but posted greater-than-expected drops since then, rising just 1.4% on the year ended May.

"Most participants viewed the recent softness in these price data as largely reflecting idiosyncratic factors," the minutes said. "However, several participants expressed concern that progress toward the committee's 2% longer-run inflation objective might have slowed and that the recent softness in inflation might persist."

Officials will receive two more monthly inflation readings before their September meeting and are likely to study those reports closely to confirm their latest forecasts.

Before Wednesday's release of the account of June's meeting, traders in futures markets placed a 19% probability on a Fed rate increase by September, and nearly a 60% probability of at least one rate increase by year end, according to CME Group.

Despite the Fed's interest rate increases, financial conditions have mostly eased, with stock markets running to new highs and the dollar falling. Yields on the 10-year Treasury were at 2.33% in mid-day trading, up from recent lows but below the 2.64% annual high set in March.

At the June meeting, Fed officials discussed reasons why financial conditions haven't tightened, including strong corporate earnings growth and growing risk tolerance among investors.

"In the assessment of a few participants, equity prices were high when judged against standard valuation measures," the minutes said. A few officials also "expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability."

The pace of hiring has slowed a touch in recent months, though the average pace of hiring over the past three months-more than 120,000 jobs per month-still exceeds the levels economists say are needed to absorb demand from a growing labor force. The unemployment rate, at 4.3%, has fallen steadily in recent months to its lowest level in 16 years, forcing Fed officials to revise down their projections of the unemployment rate.

(END) Dow Jones Newswires

July 05, 2017 14:15 ET (18:15 GMT)