New Delhi: US Federal Reserve It is set to announce on Wednesday that it will begin easing its asset purchase program earlier this month, removing the first pillar of the emergency monetary policy accommodation introduced in March 2020 to protect the economy from the Covid-19 pandemic. for.
Here’s a guide to why and how the Fed is cutting back on this key component of its crisis-era support and what it means for the shape of its future balance sheet.
What is the Fed’s asset purchase program?
The Fed has raised trillions in Treasury and mortgage-backed bonds since the start of the pandemic in a process known as quantitative easing to lower long-term interest rates, keeping financial conditions loose and boosting demand. helps, as used after the playbook. 2007-2009 financial crisis and recession.
It currently buys $80 billion in Treasuries and $40 billion in housing-backed securities each month. Since it launched the program, the Fed’s balance sheet has grown from $4.4 trillion to $8.6 trillion. $8 trillion in reserves in the Treasury and MBS account for most of its total holdings.
Why would it start reducing those purchases?
The economy, which has expanded this year at the fastest pace since the 1980s, no longer needs such extreme measures of support and keeping them in place may do more harm than good.
For example, low mortgage rates have fueled a boom in home prices, but now the problems affecting the economy are mostly supply issues, while demand, which bonds most directly affects, is upbeat and shows no signs of faltering. does not show.
“They’re doing this because the economy is really strong … the economy can stand on its own,” said former Fed economist and chair of economic advisory firm Macropolicy Perspectives, Julia Coronado.
How does tapering work?
Most likely in mid-November, the Fed will begin reducing the amount of Treasury securities purchases by $10 billion each month and mortgage-backed securities by $5 billion, eliminating them entirely by next June.
Cathy Bosjanic, chief US economist at Oxford Economics, said the Fed does not halt all bond purchases at once “to avoid shocking financial markets and to avoid sending (market) rates higher (naturally).” ”
Officials have indicated they expect the roll-off to run on autopilot, but may speed up or slow down the pace of purchases if needed.
The expected eight-month pace of tapering is also much faster than last time, indicating the Fed’s confidence in the fastest recovery in decades and of being in a position to raise interest rates to zero next year if inflation remains consistently high. desire.
What next for the Fed’s balance sheet policy?
By next June, the Fed’s balance sheet will be just over $9 trillion, roughly $8.4 trillion of which will be bonds tied to multiple rounds of QE related to the financial crisis more than a decade ago. The question is what to do after that.
Last time, it began shrinking its balance sheets two years after the Fed raised its main short-term interest rate, also known as the fed funds rate, because they did not replace securities when they mature. .
Fed watchers feel that the central bank will also be patient and passive this time around, not least because it heavily eroded the balance sheet in 2018-19.
This resulted in demand for bank reserves exceeding the Fed’s supply, leading to volatility in short-term money markets and a U-turn from the Fed, which was forced to rebalance the balance sheet to improve financial market functioning.
But that would shrink its balance sheet, wouldn’t it?
Not necessary. Last time around the Fed was focused on shrinking its balance sheet because of some discomfort with it as an untested policy tool. “After using its balance sheet as the main plank of policy twice since the Great Recession,” said Coronado, officials now understand it will be brought out of the next recession and is going to be a tool in the toolkit. .
One option, already flagged by Fed Chair Jerome Powell, would be to keep the balance sheet stable and let the economy grow in it.
As GDP grows, the balance sheet will effectively shrink as a percentage of GDP, with less impact over time. The overall balance sheet as a share of nominal GDP now stands at around 36%, almost double what it was before the pandemic.
Others are not so sure, arguing that keeping a sustainable balance sheet too large could limit its effectiveness, trigger the next recession and prompt the Fed to reduce its size again.
“These numbers are big, no matter how you look at them… over time there is reason to think about ‘generalizing’ some of these policy tools. I think they will probably experience some benefits, including this “Next time to do more quantitative easing,” said Matthew Luzzetti, chief US economist at Deutsche Bank.
What do Fed policymakers have to say?
So far, few policy makers have weighed in conclusively. Fed Governor Christopher Waller last month called for the balance sheet to shrink over the next few years by rolling out mature securities, as was the case last time.
Kansas City Fed Chair Esther George said in September that the Fed wants to keep long-term rates low while maintaining a large balance sheet, but counteracts that stimulus with a higher fed funds rate.
However, this could increase the risk of an inverted yield curve, an argument for shrinking balance sheets, George also said, neatly depicting the faces of Fed officials as they intensify discussions in the coming months. We do.
Here’s a guide to why and how the Fed is cutting back on this key component of its crisis-era support and what it means for the shape of its future balance sheet.
What is the Fed’s asset purchase program?
The Fed has raised trillions in Treasury and mortgage-backed bonds since the start of the pandemic in a process known as quantitative easing to lower long-term interest rates, keeping financial conditions loose and boosting demand. helps, as used after the playbook. 2007-2009 financial crisis and recession.
It currently buys $80 billion in Treasuries and $40 billion in housing-backed securities each month. Since it launched the program, the Fed’s balance sheet has grown from $4.4 trillion to $8.6 trillion. $8 trillion in reserves in the Treasury and MBS account for most of its total holdings.
Why would it start reducing those purchases?
The economy, which has expanded this year at the fastest pace since the 1980s, no longer needs such extreme measures of support and keeping them in place may do more harm than good.
For example, low mortgage rates have fueled a boom in home prices, but now the problems affecting the economy are mostly supply issues, while demand, which bonds most directly affects, is upbeat and shows no signs of faltering. does not show.
“They’re doing this because the economy is really strong … the economy can stand on its own,” said former Fed economist and chair of economic advisory firm Macropolicy Perspectives, Julia Coronado.
How does tapering work?
Most likely in mid-November, the Fed will begin reducing the amount of Treasury securities purchases by $10 billion each month and mortgage-backed securities by $5 billion, eliminating them entirely by next June.
Cathy Bosjanic, chief US economist at Oxford Economics, said the Fed does not halt all bond purchases at once “to avoid shocking financial markets and to avoid sending (market) rates higher (naturally).” ”
Officials have indicated they expect the roll-off to run on autopilot, but may speed up or slow down the pace of purchases if needed.
The expected eight-month pace of tapering is also much faster than last time, indicating the Fed’s confidence in the fastest recovery in decades and of being in a position to raise interest rates to zero next year if inflation remains consistently high. desire.
What next for the Fed’s balance sheet policy?
By next June, the Fed’s balance sheet will be just over $9 trillion, roughly $8.4 trillion of which will be bonds tied to multiple rounds of QE related to the financial crisis more than a decade ago. The question is what to do after that.
Last time, it began shrinking its balance sheets two years after the Fed raised its main short-term interest rate, also known as the fed funds rate, because they did not replace securities when they mature. .
Fed watchers feel that the central bank will also be patient and passive this time around, not least because it heavily eroded the balance sheet in 2018-19.
This resulted in demand for bank reserves exceeding the Fed’s supply, leading to volatility in short-term money markets and a U-turn from the Fed, which was forced to rebalance the balance sheet to improve financial market functioning.
But that would shrink its balance sheet, wouldn’t it?
Not necessary. Last time around the Fed was focused on shrinking its balance sheet because of some discomfort with it as an untested policy tool. “After using its balance sheet as the main plank of policy twice since the Great Recession,” said Coronado, officials now understand it will be brought out of the next recession and is going to be a tool in the toolkit. .
One option, already flagged by Fed Chair Jerome Powell, would be to keep the balance sheet stable and let the economy grow in it.
As GDP grows, the balance sheet will effectively shrink as a percentage of GDP, with less impact over time. The overall balance sheet as a share of nominal GDP now stands at around 36%, almost double what it was before the pandemic.
Others are not so sure, arguing that keeping a sustainable balance sheet too large could limit its effectiveness, trigger the next recession and prompt the Fed to reduce its size again.
“These numbers are big, no matter how you look at them… over time there is reason to think about ‘generalizing’ some of these policy tools. I think they will probably experience some benefits, including this “Next time to do more quantitative easing,” said Matthew Luzzetti, chief US economist at Deutsche Bank.
What do Fed policymakers have to say?
So far, few policy makers have weighed in conclusively. Fed Governor Christopher Waller last month called for the balance sheet to shrink over the next few years by rolling out mature securities, as was the case last time.
Kansas City Fed Chair Esther George said in September that the Fed wants to keep long-term rates low while maintaining a large balance sheet, but counteracts that stimulus with a higher fed funds rate.
However, this could increase the risk of an inverted yield curve, an argument for shrinking balance sheets, George also said, neatly depicting the faces of Fed officials as they intensify discussions in the coming months. We do.
.