NEW YORK (Reuters) - The U.S. Federal Reserve will stop reinvestments of its mortgage-backed securities holdings in April 2018 in an attempt to shrink its $4.2 trillion balance sheet that had ballooned from bond purchases to combat the last recession, Morgan Stanley analysts said on Friday.
Speculation about the timing and framework on the U.S. central bank's plan to pare its holdings of MBS and U.S. Treasury securities was rekindled after the Fed's policy meeting on Dec. 13-14 at which they raised interest rates by a quarter point.
In the statement issued after that meeting, the Federal Open Market Committee, the Fed's policy-setting group, said it will continue to reinvest principal payments from its MBS and Treasuries "until normalization of the level of the federal funds rate is well under way."
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Morgan Stanley analysts arrived at their call on the timing of the Fed ending its MBS reinvestments based on the Fed's projected 3 percent longer-run equilibrium interest rate, together with their own forecast of two rate hikes in 2017 and three in 2018.
"Applying this informal guidance to our expectation for the rates path leads us to believe the Fed will halt its reinvestments of MBS in April 2018," they said.
The Fed has maintained the size of its bond holdings at the current level through principal reinvestments since 2014 after its third round of large-scale bond purchases or quantitative easing ended.
"We believe the FOMC will halt its reinvestments of MBS in April 2018, preceded by a ramp-up in messaging and announcement in the March 2018 FOMC statement," Morgan Stanley analysts wrote in a research note on Friday.
The Fed's Treasuries and MBS holdings are about $2.46 trillion and $1.76 trillion, respectively. The Fed's balance sheet size is equivalent to about 22 percent of gross domestic product, according to the analysts.
"Ending Treasury reinvestments is not necessary for a gradual normalization of the balance sheet; the economy should grow into the Fed's Treasury portfolio within about a decade," said Morgan Stanley economists and strategists.
While the Fed holds more Treasuries than MBS, the analysts said halting reinvestment of MBS is easier operationally though it may result in modestly higher mortgage rates for consumers.
It is also harder for the Fed to control the outcome if it stops reinvestments in Treasuries "namely that the impact on financial conditions and the economy would be out of the Fed’s hands," they said.
(Reporting by Richard Leong; Editing by Chizu Nomiyama)