Fed Ready to Shrink Bondholdings as Soon as September -- Update

By Nick Timiraos Features Dow Jones Newswires

The Federal Reserve signaled Wednesday it is ready as soon as September to start slowly shrinking its holdings of more than $4 trillion in bonds it bought to try to buoy the economy.

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The rate-setting Federal Open Market Committee said it expects to begin shrinking the bondholdings "relatively soon," using a phrase that often has preceded action at the next policy meeting. The statement provided the group's most specific indication so far of when officials could initiate plans to taper the reinvestments of maturing Treasury and mortgage securities.

Officials offered little indication that several weak inflation readings had altered their plans to raise short-term interest rates once more this year. They voted unanimously to leave their benchmark rate in a range between 1% and 1.25%.

The Fed raised rates by one quarter percentage point in March and again in June, when officials penciled in one more quarter-point move this year. Many analysts expect that increase in December, after the Fed initiates the bond runoff process this fall.

One potential complication would be a congressional standoff over raising the Treasury's borrowing limit. The Treasury Department has employed emergency cash-conservation steps that Secretary Steven Mnuchin said should last through September. After that, the U.S. risks being unable to make timely payments on government bills if Congress hasn't raised the debt ceiling, and the threat of default could roil financial markets.

One way for the Fed to sidestep any fiscal issues would be to announce at its Sept. 19-20 meeting the start date of the portfolio runoff, and to set that date a few weeks later, well beyond the debt-limit deadline.

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Investors had expected the Fed to leave rates unchanged Wednesday and were looking for signals about whether the slowdown in inflation this spring might alter its plans for another rate increase later this year.

The statement issued after a two-day FOMC meeting noted the recent weakness in inflation but didn't deviate significantly from the statement released after last month's meeting.

After the meeting Wednesday, investors placed just a 3% probability of a rate increase in September, down slightly from before the statement was released. The probability of one rate increase by December edged down to around 50%, according to CME Group.

Fed officials completed and released their plans for the balance sheet after their June meeting, which pulled forward market expectations about when they might set the wind-down strategy into motion. At the start of the year, investors expected that wasn't likely to occur until the end of this year, or in early 2018.

But with the plans now firmly in place -- and with few signs of inflation pressures building despite low unemployment -- officials have hinted they are ready to initiate the wind-down earlier and to defer another rate increase until later in the year, which would give them more time to assess inflation data.

The Fed bought more than $4 trillion in Treasury and mortgage securities during and after the financial crisis to stimulate the economy by holding down long-term rates. Allowing the balance sheet to decline could cause long-term rates to rise.

The Fed stopped adding to its balance sheet in late 2014, but the central bank has been reinvesting the proceeds of maturing assets to keep the holdings steady. Officials have taken pains to avoid surprising markets about its plans for the balance sheet, as seen in Wednesday's statement teeing up a likely September announcement.

Fed Chairwoman Janet Yellen is scheduled to answer questions from the media at the September meeting, providing an opportunity to explain the committee's thinking. She could have an opportunity to elaborate on the Fed's plans at the end of next month, when the Fed leader traditionally speaks at an annual economic policy symposium in Jackson Hole, Wyo.

While some Fed critics have warned the central bank risks fueling low volatility and financial instability by over-preparing markets for its every move, other analysts have said it is entirely appropriate to treat a major inflection point, such as the balance-sheet wind-down, extremely carefully.

"You never know how the market is going to respond to something like this, so kid gloves are appropriate," said Lou Crandall, chief economist at Wrightson ICAP. By contrast, "it would not bother me in the least if the outlook for rate hikes became a little less predictable."

The Fed won't actively sell assets. Instead, it will allow a preset amount of holdings to mature every month without reinvestment. The amounts allowed to mature would initially be set at a relatively low level -- $10 billion a month -- and they would increase every quarter by $10 billion up to a maximum of $50 billion. Officials have said they want the plan to run quietly in the background once it starts.

Markets have largely taken the Fed's plans in stride. Major stock indexes and other asset prices, including housing, have advanced steadily higher. Financial conditions have eased despite three interest-rate increases by the Fed in the past three quarters.

"Relative to where we were last year, earnings are better and... growth is accelerating domestically and globally," said Ed Al-Hussainy, senior global rates strategist at Columbia Threadneedle Investments.

Inflation has been the fly in the ointment for the Fed. Its preferred measure of inflation declined in March from a month earlier after a drop in the prices of wireless phone plans. Inflation pressures have remained soft in the months since then, making it more difficult for Fed officials to dismiss the declines as resulting from one-off factors, as they did after meetings in May and June.

Ms. Yellen told lawmakers earlier this month "there may be more going on" than a series of idiosyncratic price declines, but she also said it was "premature" to conclude underlying inflation was falling well short of the Fed's 2% target. "We have quite a tight labor market, and it continues to strengthen," she said.

The weakness on the inflation front is puzzling because unemployment has fallen to levels suggesting much less slack remains in the labor market, which Fed officials and many economists expect ultimately should force employers to boost wages and prices.

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

July 26, 2017 18:44 ET (22:44 GMT)