How does reducing the Fed’s bond purchase work?

The Federal Reserve (Fed) from USA announced on Wednesday that it will begin to reduce its asset purchase program this month, eliminating a first pillar of the expansionary emergency monetary policy introduced in March 2020 to protect the economy from the pandemic of the COVID-19.

The following is a guide to why and how the Fed is cutting this key component of its crisis-era support and what that means for its balance sheet.

What is the Fed’s Asset Purchase Program?

Since the start of the pandemic, the Federal Reserve has bought trillions of dollars in Treasury bonds and mortgage-backed securities (MBS) in a process known as quantitative easing (QE) to lower long-term interest rates, maintain conditions expansionary financials and help stimulate demand, similar to what it did during the financial crisis and recession of 2007-2009.

Currently, the Fed buys $ 80 billion in Treasuries and $ 40 billion in mortgage-backed securities every month. Since the program began, the Fed’s balance sheet has increased from $ 4.4 trillion to $ 8.6 trillion. The $ 8 trillion of Treasury and MBS bonds represent the majority of its assets.

Why will you start reducing purchases?

The economy, which is on track to grow at the fastest pace since the 1980s, no longer needs such extreme support measures and maintaining them could do more harm than good. For example, low interest rates on mortgages have fueled the house price boom, but the problems now plaguing the economy are mostly supply problems, while demand, which is most directly affected by bond buying is booming and showing no signs of weakness.

“They do it because the economy is really strong. The economy can sustain itself, ”said Julia Coronado, a former Fed economist and president of the economic advisory firm MacroPolicy Perspectives.

How does tapering work?

The Fed announced Wednesday that in mid-November and December it will reduce the value of purchases of Treasury securities by $ 10 billion and of mortgage-backed securities by $ 5 billion. It expects to continue that pace of cuts in the coming months, which means it would eliminate bond purchases entirely in June. The Fed doesn’t stop them all at once “to prevent financial markets from freaking out and sending (market) rates above what they would (naturally) be,” said Kathy Bostjancic, chief US economist at Oxford Economics.

Officials also said they could speed up or slow down the pace of purchases if necessary. The expected eight-month pace of reduction is also much faster than last time, showing the Fed’s confidence in the steepest recovery in decades and a desire to be in a position to raise interest rates from close range. from zero next year if inflation remains persistently high.

What will happen to the Fed’s balance sheet?

By next June, the Fed’s balance sheet will stand at just over US $ 9 trillion, of which about US $ 8.4 trillion will be bonds associated with multiple rounds of quantitative stimulus dating back to the financial crisis of more than 12 months ago. of a decade. The question is what to do next.

The last time, the Fed began reducing its balance sheet two years after it began raising its main short-term interest rate, also known as the Fed funds rate, not replacing securities as they matured. Fed watchers believe the central bank will also be patient and passive this time, not least because it slashed the balance sheet too much in 2018-2019.

The decline caused the demand for bank reserves to exceed the supply of the Fed, causing volatility in the short-term money markets and a 180 degree turn of the Fed, which was forced to increase the balance again to improve the operation of financial markets.

But it will reduce the balance, right?

Not necessarily. Last time, the Fed focused on reducing its balance sheet because there was some discomfort with it as an untested monetary policy tool. Having used his balance sheet as a mainstay of monetary policy twice since the Great Recession, “officials now understand that it is going to be brought out in the next recession and that it is going to be a tool in the box,” Coronado said.

One option, already outlined by Fed Chairman Jerome Powell, would be to simply keep the balance sheet stable and let the economy go with it. As gross domestic product grows, the balance would effectively shrink as a percentage of GDP, exerting less influence over time.

The total balance as a percentage of nominal GDP is now almost 36%, about double what it was before the pandemic.

Others are not so sure, arguing that keeping too large a permanent balance could limit its effectiveness in the next recession.

“These figures are large no matter how you look at it. There are reasons to think about ‘normalizing’ some of these monetary policy tools over time. I think there will probably be some benefits, in the sense that there will be more scope to do more quantitative easing next time, ”said Matthew Luzzetti, chief US economist at Deutsche Bank.

What do the members of the Fed say?

So far, few policy makers have spoken out clearly. Last month, Fed Governor Christopher Waller called for the balance sheet to be reduced over the next two years by allowing maturing securities to shrink, similar to last time.

Kansas City Fed Chair Esther George said in September that the Fed may want to keep long-term interest rates low while maintaining a large balance sheet, but offsetting that stimulus with a lower Fed funds interest rate. high.

However, this could increase the risk of an inverted yield curve, an argument for reducing the balance sheet, George also said, clearly illustrating the dilemma facing Fed officials as they intensify discussions in the coming months.