As Fed Sets to Unwind, How Far Should It Go?

By Nick Timiraos Features Dow Jones Newswires

The Federal Reserve is set to announce Wednesday it will start passively shrinking its massive portfolio of bondholdings. But the central bank has left one piece of its plan undecided: the target size of the portfolio.

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The Fed ran its portfolio of bonds and other assets, also known as its balance sheet, from less than $900 billion in 2008 to $4.5 trillion in 2014, a level it has maintained ever since as it reinvests the payments of maturing bonds. The central bank is going to allow a small but rising number of bonds to roll off every month, eventually working up to letting $50 billion in bonds mature every month without reinvestment.

Fed Chairwoman Janet Yellen found a way to shrink the bondholdings with unanimous support from the Federal Open Market Committee, suggesting the policy-setting panel would set a high bar for changing course if Ms. Yellen doesn't serve a second term after her current one expires next February.

One question that will fall to whoever is Fed leader in future years, however, is when to end this process of letting assets roll off the central bank's books. Though the assets will shrink, the Fed will still end up with more assets than before the crisis because its liabilities have grown. There is more currency in circulation, and the Treasury has a larger cash balance than it did before the crisis. With more liabilities, the Fed will maintain more assets.

Changes in how it sets interest rates also will leave the portfolio larger than before. Before 2008, banks held relatively low levels of deposits -- known as reserves -- at the Fed. The central bank managed its benchmark federal-funds rate by making small adjustments in the amount of these reserves through routine purchases and sales of Treasury securities.

Now, with a large portfolio of securities, the Fed has left the banking system flush with trillions of dollars in reserves. It manages rates now by paying interest on these reserves. New York Fed President William Dudley said this month he prefers keeping some level of excess reserves in the banking system -- perhaps $400 billion to $1 trillion -- which will mean keeping a larger portfolio of securities than prevailed before the crisis.

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This relatively new way of setting rates "is much easier to manage on a day-to-day basis," Mr. Dudley said.

Several officials in addition to Mr. Dudley have said they prefer setting rates by paying interest on reserves. Critics outside the Fed have said maintaining the larger balance sheet necessary to do so keeps a political target on the central bank's back, in part because the larger holdings could provide a way for Congress to engage in credit policy that proves irresistible over time.

The upshot is that while the terminal size of the holdings isn't clear now, the balance sheet is likely to shrink by much less than it grew between 2008 and 2014. While the Fed added $3.7 trillion in bondholdings after the crisis, it could shrink by only "roughly $1 trillion to $2 trillion," according to New York Fed staff projections cited by Mr. Dudley.

Moreover, while Fed officials have expressed a desire to return to a Treasurys-only portfolio, meaning they would unload all of the mortgage-backed securities they purchased in recent years, that will take a long time under the plan the Fed is preparing to set into motion.

The reason: As long as interest rates remain not much lower than they currently are, mortgages might pay off much slower than they used to. If interest rates rise much from their recent all-time lows, more homeowners could decide it is cheaper for them to stay with their current ultralow rate than to move to a new home that requires them to give up that loan. Reduced mobility would slow the rate at which mortgage bonds pay off.

The Fed currently has around $1.7 trillion in mortgage-related assets, mostly bonds issued by Fannie Mae, Freddie Mac and Ginnie Mae. Laurie Goodman, a mortgage expert at the Urban Institute, estimates that five years from now, the Fed could still own $1 trillion in mortgage bonds.

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

(END) Dow Jones Newswires

September 18, 2017 15:35 ET (19:35 GMT)