The next steps for US Fed policy
14 June 2017 | Markets and Economy
Whenever US Federal Reserve policymakers raise interest rates, the decision inevitably draws plenty of attention from investors. But a Fed rate hike – including the one announced on 14 June – isn't the only policy aspect with significance for investors in the United Kingdom and worldwide.
As the Fed continues to move forward with monetary policy normalisation, its scope of action is to widen to include the sensitive task of reducing its US$4.5 trillion portfolio [about £3.6 trillion] of debt securities, including US Treasury notes and mortgage-backed securities.
The Fed accumulated this massive balance sheet by aggressively purchasing securities after the global financial crisis. The heavy buying was aimed at lowering interest rates and, ultimately, stimulating economic activity. Now, the challenge for the Fed is to trim its portfolio without unduly affecting the US economy or the global financial markets.
We discussed what's ahead for Fed policy with two Vanguard experts: Senior Economist Andrew Patterson and Senior Fixed Income Portfolio Manager Gemma Wright-Casparius.
About four years ago, the markets had a "taper tantrum" when the Fed announced it would start slowing the pace of quantitative easing, as its security purchases are known. Do you expect a similar reaction as the Fed starts shrinking its balance sheet?
Gemma Wright-Casparius: The Fed learned a powerful lesson in 2013 on the need to exhaustively communicate major shifts in policy and to do so well in advance of implementation.
The seemingly offhand announcement of the shift from unlimited quantitative easing to raising short-term interest rates caught the market by surprise. Long-term rates shot higher, hurting financial conditions, especially for the housing market. It took many months to calm market fears, which reinforced the need for the Fed to be slow and transparent with its policy guidance when interest rates are so close to zero.
Andrew Patterson: We would expect the impact on markets from the Fed's trimming its balance sheet to be relatively small and front-loaded, occurring largely when the announcement is made. However, the market reaction this time should be mitigated by the groundwork the Fed has laid in communicating its intentions.
As Gemma said, the taper tantrum was initiated by a surprise comment about reducing the pace of purchases, which reset investor expectations for the size of the balance sheet, the length of time that rates would remain near zero, and many other factors. This time, though, the Fed has been more up front in communicating potential policy changes.
Earlier this year, several Fed policymakers, including Chair Janet Yellen, William Dudley and one of the more dovish among them, Lael Brainard, spoke in general terms about the possible timing and implementation of a wind-down. The Federal Open Market Committee (FOMC) shared more detailed discussions of a framework to do so in the minutes of its May meeting released a few weeks ago, and we received more clarity from Yellen's press conference on Wednesday.
How will the Fed begin unwinding its balance sheet?
Andrew Patterson: We know that the Fed's actions are data-dependent, so if expectations remain in place for the US economy to continue strengthening, the labour market to keep tightening and inflation to move closer to the Fed's target of 2%, further policy action can be expected.
The pace of monetary policy normalisation will remain slow and steady, however, and the Fed will probably use only one tool at a time at first – either rate hikes or balance-sheet reductions. I say that because there's broad acknowledgement that its bond purchases to bolster economic conditions were unprecedented, so it would be prudent for the Fed to proceed with reducing those holdings gradually while putting rate hikes on the back burner in order to evaluate the real-world impact.
So to answer your question, our "base" scenario is that we may see another rate hike before the Fed pauses to finalise, communicate and then implement a balance-sheet reduction program. In our view, that's all likely to occur before year-end.
Can you elaborate on the Fed's strategy?
Andrew Patterson: The Fed's thinking on how to cut its holdings has evolved. As early as 2011, when it started formulating a plan for an eventual reduction, sales of securities were in the mix. Since then, however, expectations about the optimal size of the balance sheet have risen significantly, meaning the Fed can probably reduce its $2.75 trillion [about £2.17 trillion] in Treasuries and $1.75 trillion [about £1.38 trillion] in mortgage-backed securities simply by letting them mature – an approach that would be less disruptive, especially to the mortgage market, than outright asset sales.
The Fed's ultimate goal is to have such a roll-off program run passively in the background in a gradual and predictable manner with minimal market impact.
A cap system floated at the FOMC's May meeting seemed to have broad support among its members. Under that system, a specific dollar amount of maturing securities would be allowed to roll off the balance sheet each month. If all goes well, that dollar cap could be increased quarterly until the optimal balance-sheet level – which wasn't disclosed – is reached.
The Fed would have more than enough securities maturing in the near term to reduce the balance sheet to a reasonable level. About $1.4 trillion [about £1.11 trillion] in Treasuries alone – more than half of the Fed's Treasury holdings – will reach maturity over the next five years.
Andrew mentioned that the Fed will be trying not to disrupt the bond market as it lightens its balance sheet, but is that possible given how much debt it is likely to unload? And what might it mean for investors?
Gemma Wright-Casparius: How successful the Fed will be in winding down its real-world monetary policy experiment without roiling the market or the economy remains to be seen.
Allowing holdings to mature will not in and of itself push interest rates or mortgage rates higher. Moreover, adopting a very transparent forward-guidance strategy could help the Fed mitigate the potential policy impact, while allowing interest rates to be driven by the pace of economic activity and the future path of policy rate hikes.
What may potentially impact the market is how the Treasury will fund the federal budget deficit without the Fed's purchases over the long run. The Fed is not price-sensitive when it buys bonds, but market-based buyers will be. As a result, once the cumulative reduction in the balance sheet becomes significantly large, long-term risk premium could rise if the Treasury issues more long-maturity bonds, pushing up the yield on longer-dated securities. We expect the impact to be less than what we saw with the taper tantrum, as the US remains an attractive investment opportunity for global investors.
It is important for investors to look past short-term volatility and adhere to long-term investment strategies. And keep in mind that higher rates, if they were to occur, allow for reinvestment of maturing bonds and cash flows at higher rates, resulting in higher yields on your bond holdings.
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