How the Fed's Unwinding Will Work

The Federal Reserve is likely to announce Wednesday the start of its plan to slowly and passively pare its massive bondholdings. Here are answers to three of the most commonly asked questions from our readers about how it works.

Q: OK, I know the Fed accumulated the holdings by buying bonds. And I've read that it will shrink the portfolio by letting limited amounts of them mature, which means it will receive principal payments from the issuers. So what will the Fed do with that money?

A: The Fed essentially created money out of thin air to buy the bonds. Now, it will destroy the money the same way.

The central bank has been reinvesting the proceeds from maturing Treasurys and mortgage-backed securities to keep its portfolio steady at around $4.5 trillion. It will soon begin to allow small amounts of these bonds to mature without any reinvestment.

To explain what it does with the money it helps to recall how it bought the bonds in the first place. When private investors buy bonds, they use cash, borrow funds or sell assets to raise the money to make that purchase.

The Fed is different. It doesn't have to do any of those things because it has the power to electronically credit money to the bank accounts of bond dealers who sell mortgage-backed securities or Treasurys. The Fed gets the securities, and the seller sees its account increase by the same amount as the securities' value. The Fed isn't literally printing paper currency to do this, but it is creating funds electronically that weren't in the financial system before.

This process is about to go into reverse. Instead of reinvesting the proceeds of maturing bonds, the Fed will erase them electronically. It won't be destroying any paper currency, but the money essentially vanishes from the financial system.

The New York Fed provides a detailed breakdown of the accounting on its Liberty Street Economics blog.

The Fed plans to move gradually. For the first quarter -- probably to begin in October -- it will allow $6 billion in Treasurys and $4 billion in mortgage bonds to roll off every month. Anything beyond those limits still will be reinvested. Every quarter, those amounts will increase until after a year, when the Fed will allow up to $30 billion in Treasurys and $20 billion in mortgages to expire without any reinvestment.

One important caveat: The Fed isn't going to sell any bonds.

Q: Why is the Fed doing this now?

A: First, the economy is on stronger footing. The Fed has raised short-term interest rates four times in the last two years, and with borrowing costs comfortably above zero, it is ready to unwind the last, big piece of its unprecedented response to the 2008 financial crisis.

Second, the Fed's large holdings have become a political liability, leaving critics sour over the experimental crisis-era rescue efforts. Some Republican lawmakers didn't like that the Fed's measures to keep interest rates low helped reduce the size of budget deficits under President Barack Obama. Other critics say the Fed's purchases of mortgage-backed securities to support the housing market were a form of fiscal policy that would have been better left to lawmakers.

Third, starting the process now also removes uncertainty for financial markets about what the Fed plans to do with its balance sheet, particularly given another source of uncertainty -- a looming leadership reshuffle at the Fed. Within the next year, President Donald Trump will have a chance to name five of the seven members of the Fed's board, including its chairman and vice chairman. By agreeing to a plan now -- and doing so unanimously -- the Fed has put in place a process that could be harder for its future leaders to change.

Q: If the bond-buying programs are assumed to have been so stimulative for the economy on the way in, why haven't markets reacted more this summer to the coming end of bond reinvestments?

A: In 2013, Fed officials' public comments about plans to slow down bond purchases triggered a sharp market reaction known as the taper tantrum. That hasn't happened so far this time around. It could be a combination of luck, timing and skill.

Since the Fed stopped adding to its balance sheet, the European Central Bank has launched its own asset-purchase program and the Bank of Japan is also buying assets. It's possible markets won't react to what's happening until the ECB starts to dial down its purchases.

Moreover, the Fed has unveiled a very gradual approach. It never fully stops reinvestments, and it will take about a year for the Fed to ramp up the process of shrinking its holdings. Richard Clarida, an economist at Pacific Investment Management Co., or Pimco, compares the pace to a diet that calls for eating two desserts a day instead of three.

Third, the Fed has been more precise in communicating its plans this time. During the taper tantrum, markets mistakenly inferred the Fed's decision to slow down its asset purchases also meant it was rethinking the path of interest-rate increases. This time, the Fed has made clear that its decision to shrink the balance sheet doesn't imply any desire to change its rate-setting plans.

Finally, some of the benefit of the Fed's bond-buying programs was psychological, the equivalent of "shock and awe" for finance. The world's leading central bank showed markets that even though it had already cut interest rates to near zero, it had an array of stimulus tools ready to deploy should the economy require it, including the bond buying sometimes called quantitative easing, or QE. "A lot of the benefit was psychological, and people are not now feeling that this is QE in reverse," said Lou Crandall, chief economist of Wrightson ICAP.

The asset-buying programs also may have provided a bigger boost because they helped repair credit markets that had frozen. Now that markets are working again, reversing the program might not have as great an effect.

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

(END) Dow Jones Newswires

September 19, 2017 13:15 ET (17:15 GMT)