The Wall Street Journal
Fed Officials Develop Plan to Shrink Central Bank's Mortgage Portfolio
Federal Reserve officials have agreed to sell some of the central bank's $1.1 trillion of mortgage-backed securities at some point, but have been unable to reach a firm consensus on how soon or how aggressively to do that, according to several people familiar with the matter.
Many Fed officials want to wait until after the central bank has started to raise short-term interest rates and tighten financial conditions, which could be many months away, but a minority is eager to move sooner.
The internal debate about the Fed's mortgage portfolio is important to households and investors because sales of mortgage securities could push down prices of the securities and push up mortgage borrowing costs.
Fed officials have been debating asset sales for months. Minutes of the Fed's late April meeting, due out in two weeks, are likely to show the debate has intensified but hasn't been completely resolved. The Fed started buying the securities in early 2009 as part of an effort to drive down long-term interest rates to speed an economic recovery. But now, most officials are uncomfortable holding them.
One issue underlying the debate is inflation expectations. Some Fed officials worry that holding such a large portfolio—which entails pumping money into the financial system to fund the purchases—fuels fears that the Fed will allow inflation to take hold in the future.
Sale proponents also are averse to holding instruments that seem to favor housing over other parts of the economy. But many officials worry that markets would interpret even a program of modest sales as a sign that the Fed wants to tighten credit, before it is actually prepared to do so or before the economy could bear it.
The Fed's conventional way of tightening credit is to raise a short-term interest rate called the federal-funds rate, which is what banks charge each other on overnight loans. Many officials are inclined to maintain that as their main mechanism for tightening policy when the time comes, and to put mortgage sales on a slow track at first.
One approach attracting a following within the Fed: After the economy improves enough, the Fed would change the way it communicates to the market, no longer saying rates would stay low for an "extended period." Then, it would pull some cash out of the financial system with operations called reverse repos and term deposits. Next, it would raise short-term rates by increasing the rate the Fed pays banks to keep money on reserve at the central bank. Then it would announce a modest asset-sales program that it might ratchet up after six to nine months as recovery gains steam.
"The best argument for this sequence is that the Fed and markets have lots of experience analyzing the effects of rate hikes and should be able to gauge their effects with reasonable accuracy," economists at Goldman Sachs said in a commentary on the Fed's debate earlier this week.
The goal would be to substantially reduce the Fed's mortgage holdings within four or five years after tightening starts. Fed officials believe they will need to sell substantially less than their overall holdings of $1.1 trillion because many of the securities will retire on their own as borrowers refinance mortgages and the securities mature.
The idea of ratcheting up sales later is one that is gaining support at the Fed and could be a compromise to allay the worries of the officials most eager to dispose of the securities. The Fed would also have the option of tapering down the sales if the economy responded poorly.
"I would start slow and then move based on the economy," James Bullard, President of the St. Louis Fed, said in an interview with the Wall Street Journal last week. "I would want to ensure markets that you would do it slowly over a longer period of time."
The process of just getting started could take as much as a year or more to unfold, depending on how the economy performs. Though the Fed's anti-inflation hawks want to get going soon, many officials are still comfortable with their assurance to the public that rates will stay low for an extended period because inflation might still be slowing and unemployment is high.
"With inflation expectations stable, core inflation rates declining, and significant excess capacity in the economy, accommodative monetary policy remains appropriate," Federal Reserve Bank of Boston President Eric Rosengren told a gathering in New York Wednesday night.
An added reason for caution: Rising concern about financial risks in Europe related to Greece's debt woes. Though Greece is small relative to the U.S., Fed officials are concerned that turmoil in European markets could spill into U.S. markets and hurt the recovery here.
Many Fed officials want to wait until after the central bank has started to raise short-term interest rates and tighten financial conditions, which could be many months away, but a minority is eager to move sooner.
The internal debate about the Fed's mortgage portfolio is important to households and investors because sales of mortgage securities could push down prices of the securities and push up mortgage borrowing costs.
Fed officials have been debating asset sales for months. Minutes of the Fed's late April meeting, due out in two weeks, are likely to show the debate has intensified but hasn't been completely resolved. The Fed started buying the securities in early 2009 as part of an effort to drive down long-term interest rates to speed an economic recovery. But now, most officials are uncomfortable holding them.
One issue underlying the debate is inflation expectations. Some Fed officials worry that holding such a large portfolio—which entails pumping money into the financial system to fund the purchases—fuels fears that the Fed will allow inflation to take hold in the future.
Sale proponents also are averse to holding instruments that seem to favor housing over other parts of the economy. But many officials worry that markets would interpret even a program of modest sales as a sign that the Fed wants to tighten credit, before it is actually prepared to do so or before the economy could bear it.
The Fed's conventional way of tightening credit is to raise a short-term interest rate called the federal-funds rate, which is what banks charge each other on overnight loans. Many officials are inclined to maintain that as their main mechanism for tightening policy when the time comes, and to put mortgage sales on a slow track at first.
One approach attracting a following within the Fed: After the economy improves enough, the Fed would change the way it communicates to the market, no longer saying rates would stay low for an "extended period." Then, it would pull some cash out of the financial system with operations called reverse repos and term deposits. Next, it would raise short-term rates by increasing the rate the Fed pays banks to keep money on reserve at the central bank. Then it would announce a modest asset-sales program that it might ratchet up after six to nine months as recovery gains steam.
"The best argument for this sequence is that the Fed and markets have lots of experience analyzing the effects of rate hikes and should be able to gauge their effects with reasonable accuracy," economists at Goldman Sachs said in a commentary on the Fed's debate earlier this week.
The goal would be to substantially reduce the Fed's mortgage holdings within four or five years after tightening starts. Fed officials believe they will need to sell substantially less than their overall holdings of $1.1 trillion because many of the securities will retire on their own as borrowers refinance mortgages and the securities mature.
The idea of ratcheting up sales later is one that is gaining support at the Fed and could be a compromise to allay the worries of the officials most eager to dispose of the securities. The Fed would also have the option of tapering down the sales if the economy responded poorly.
"I would start slow and then move based on the economy," James Bullard, President of the St. Louis Fed, said in an interview with the Wall Street Journal last week. "I would want to ensure markets that you would do it slowly over a longer period of time."
The process of just getting started could take as much as a year or more to unfold, depending on how the economy performs. Though the Fed's anti-inflation hawks want to get going soon, many officials are still comfortable with their assurance to the public that rates will stay low for an extended period because inflation might still be slowing and unemployment is high.
"With inflation expectations stable, core inflation rates declining, and significant excess capacity in the economy, accommodative monetary policy remains appropriate," Federal Reserve Bank of Boston President Eric Rosengren told a gathering in New York Wednesday night.
An added reason for caution: Rising concern about financial risks in Europe related to Greece's debt woes. Though Greece is small relative to the U.S., Fed officials are concerned that turmoil in European markets could spill into U.S. markets and hurt the recovery here.
