The Federal Reserve on Wednesday set a start date for reducing its massive holdings of government bonds, nine years after it began buying financial assets in bulk to try to counteract the collapse of Wall Street.
Federal Reserve officials announced after a two-day meeting in Washington that they planned to slowly decrease the size of the central bank’s balance sheet, currently swollen to $4.5 trillion, beginning in October. All nine members of the monetary policy committee voted for the action.
The long-awaited move was the biggest news from Wednesday’s meeting, at which Chairwoman Janet Yellen and the Fed’s rate-setting committee declined to change their short-term interest rate target.
Officials did, though, pencil in a third rate hike before the end of the year, which would bring the target up to between 1.25 percent and 1.5 percent. They mostly shrugged off the impact of Hurricanes Harvey and Irma on the economy, saying that they “are unlikely to materially alter the course of the national economy over the medium term,” other than temporarily lifting inflation because of higher prices for gas and other goods for which the supply chain was disrupted.
In fact, the Fed members now project faster economic growth for 2017, with a median forecast of 2.4 percent gross domestic product growth, versus a June projection of 2.2 percent.
Investors reacted to the statement by pricing in higher odds of an increase in the target interest rate in December. Previously, they had seen it as a fifty-fifty proposition.
The move to shrink the Fed’s balance sheet is one that the central bank has taken care to carry out without spooking markets.
The balance sheet will shrink slowly. Fed officials have said that they will reduce it by $10 billion in Treasury and mortgage-backed securities a month, to start, by allowing bonds to mature without buying new ones.
It’s a plan meant to be cautious, one that has been developed and carefully explained to investors over the course of years.
Previously, the Fed has struggled to explain how it would move away from emergency measures to more normal monetary policy. Famously, former Chairman Ben Bernanke in 2013 caused a mini-panic in bond markets, the “taper tantrum,” simply by surprising investors with the news that the Fed would slow its purchases of bonds.
For Fed officials, scaling back the central bank’s balance sheet is a task with little precedent to rely on, just as ramping up those holdings during the crisis was.
In fall 2008, as the subprime crisis threatened to take down the entire banking system, the Fed began purchasing hundreds of billions of dollars worth of credit to prop up financial institutions. By 2009, its holdings had increased from about $900 billion to more than $2 trillion.
As the recovery threatened to fail, however, Bernanke and company announced a program of “quantitative easing,” or large-scale purchases of Treasury securities and mortgage-backed securities guaranteed by the government. The Fed’s logic was that by buying bonds, it would drive up their price. The corresponding lower interest rates would encourage people to borrow to buy houses and companies to finance new investments. New spending would boost the recovery.
The Fed ended its purchases in late 2014, as the unemployment rate fell near 5.5 percent. Now, the central bank owns just under a third of all government-guaranteed mortgage-backed securities and about an eighth of all Treasury securities.
With unemployment now at 4.4 percent, the view from within the Fed is that the time is right to begin reversing the measures it took during the recession.
Partly, they will do so to prevent inflation from rising out of the Fed’s control, which many members believe is inevitable if unemployment keeps falling and the economy keeps improving.
There are also practical reasons they want a smaller balance sheet over time. It will allow them to manage monetary policy with the tool — short-term interest rates — they long used before the crisis.
Yet they’re phasing in the plan slowly. In June, Yellen said the drawdown “will be like watching paint dry, that this will just be something that runs quietly in the background.”
The plan, approved unanimously by the monetary policy committee in March, is meant to take place over the course of years, to be finished after most of the Fed’s current members are likely to have moved on.
In fact, the Fed hasn’t set an end date for shrinking the balance sheet. Federal Reserve Bank of New York President William Dudley said this month that it was possible the balance sheet could stabilize at between $2.4 trillion to $3.5 trillion in the early 2020s.
