Federal Reserve officials announced Wednesday that they would hold off on raising their interest rate target this month, leaving it at 1-1.25 percent, but also indicated that they will soon start shrinking the massive portfolio of bonds the central bank built up in fighting the recession.
Wednesday’s decision not to raise rates was expected. Markets anticipate that the central bank might raise interest rates again by the end of the year, which would mean three rate increases this year.
With inflation falling in recent months, though, counter to the Fed’s expectations, there is no rush to tighten monetary policy. In fact, some Fed officials have raised concerns that the central bank may be at risk of falling short of its 2 percent inflation target.
For now, the biggest question about the Fed’s intentions is whether it will begin shrinking its $4.5 trillion balance sheet at its next monetary policy meeting in September.
The answer to that question appears to be “yes.” On Wednesday, the Fed’s monetary policy committee statement said they would begin letting the balance sheet decrease in size “relatively soon,” as long as the economy holds up.
“A start date for the balance sheet normalization is all tee’d up for the September meeting,” said Greg McBride, chief financial analyst for Bankrate.com.
The Fed’s plans for selling off its holdings of Treasury and mortgage-backed securities are of critical interest to investors. By selling bonds, the Fed lowers their prices. Accordingly, interest rates rise (bond rates move in the opposite direction from prices).
In theory, that upward pressure on interest rates should lead companies and families to borrow less to finance spending, lessening the risk of inflation surging out of control in the next few years. The effect would roughly be the opposite of what happened when the Fed bought the bonds in several stimulus campaigns in the wake of the financial crisis. Those large-scale bond-buying programs are commonly referred to as “quantitative easing.”
Fed members have cautiously begun planning to reverse the massive bond purchases they made during the crisis, but they are still figuring out how to go about accomplishing the drawdown.
As spelled out, the plan is not to sell off bonds. Rather, the Fed will simply let the bonds mature, and then, in increments, stop rolling over some of the proceeds into new bonds. At first, they’ll allow the balance sheet to shrink by $10 billion a month, but that could ramp up to $50 billion.
Goldman Sachs economists reckoned Tuesday that the Fed might follow that course until its holdings drop to $3 trillion in 2021.
