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What could drive the Fed to a ‘Plan B’ for balance sheet reduction – Metro US

What could drive the Fed to a ‘Plan B’ for balance sheet reduction

FILE PHOTO: The U.S. Federal Reserve Board building in Washington
FILE PHOTO: The U.S. Federal Reserve Board building in Washington

(Reuters) – Amid a strong U.S. housing market, low interest rates and unnervingly high inflation, the Federal Reserve has been adding to its bond portfolio even to this day, prompting calls to not just let the securities expire over time but to lay plans to begin selling them outright.

It’s unlikely that any sales would be included at the start of the balance sheet “normalization” plans officials are expected to approve in the coming months, a process that will run alongside interest rate hikes aimed at becalming inflation.

But if the fight against inflation doesn’t succeed fast enough, some Fed officials want a “Plan B” that would venture into new territory and use sales of mortgage-backed securities (MBS) to raise home mortgage rates, one of the key channels that the U.S. central bank can use to lower inflation because it holds down home prices and leaves less room in household budgets for other spending.

Fed officials discussed the possibility of MBS sales at their Jan. 25-26 policy meeting, with “many participants” saying it might be appropriate “at some point in the future,” minutes from the meeting showed on Wednesday.

Home borrowing costs are already rising rapidly, with the average contract rate on a 30-year fixed-rate mortgage popping above 4% this month for the first time since 2019, according to the Mortgage Bankers Association. Even before the Fed’s first rate hike – expected to come next month – or the first bond matures from its portfolio without replacement, that key consumer interest rate has surged a full percentage point in less than six months.

Mortgage rates are climbing fast – https://graphics.reuters.com/USA-FED/jnvwelnwdvw/chart.png

Still, the Fed’s $2.7 trillion MBS stockpile acts as an anchor on interest rates in that market, preventing them from being even higher, and some officials argue the central bank’s footprint may need to shrink faster than it would through natural “runoff.” That process, of securities rolling off the balance sheet as they mature, is particularly slow and unpredictable for MBS and may take longer when rates are rising.

“I still keep that option open in scenarios where inflation is not moderating in the way we hoped and we are going to have to get a little tougher,” St. Louis Fed President James Bullard told Reuters at the start of February.

And speaking on CNBC this week, Bullard said he supports starting the balance sheet reduction in the second quarter of this year through the passive approach and then using asset sales as a “Plan B” if needed to “speed up the pace.”

DECIDING EXIT STRATEGY

Investors are keen to know how the Fed is going to unwind more than $8 trillion of MBS and Treasury securities – a portfolio that doubled during the coronavirus pandemic as the central bank snapped up the assets to stabilize markets and the economy.

Bond purchases have long been a controversial aspect of monetary policy in part because of lingering questions around the exit strategy, with some critics arguing that selling securities when interest rates are rising can cause the central bank to lose money. Bond prices fall when interest rates are rising and vice versa.

The Fed avoided bond sales when it last reduced the balance sheet between 2017 and 2019. Policymakers want to rely primarily on the runoff strategy this time around too, according to principles released last month.

The first “QT” – https://graphics.reuters.com/USA-FED/BALANCESHEET/jnvwelojbvw/chart.png

But some Fed officials and analysts say that passive approach could fall short. Bullard and Kansas City Fed President Esther George are among those who have pointed to high inflation as a concern.

Sales may also be needed to help the Fed meet its goal of moving to a portfolio that is made up mostly of Treasury securities in the long run, Cleveland Fed President Loretta Mester recently said.

Part of the issue lies with the Fed’s mortgage holdings, which are expected to move off its balance sheet more slowly than its Treasury holdings once the shrinkage of the portfolio is initiated.

For example, about $2.5 trillion of the Fed’s Treasury holdings have short maturities and would come due in the next three years, according to an analysis by the fixed income team at the Schwab Center for Financial Research. But it’s difficult to know exactly how long it will take for the Fed’s mortgage holdings to roll off the balance sheet, analysts say.

Portions of the securities are prepaid early as people sell their homes or refinance their loans, which leads them to pay their mortgages off ahead of the initial due date. And it typically takes time for MBS to roll off the balance sheet naturally.

Between October 2017 and September 2017, the Fed capped the monthly reductions at $50 billion, but the actual decline was typically much less than that. Policymakers want to move faster this time, but are concerned the Fed’s mortgage holdings will prove “sticky,” particularly when mortgage rates are rising.

That’s because fewer people refinance their mortgages when rates are going up, which slows the rate of loan prepayments, said Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research.

In fact, that may already be happening. MBA’s data shows that refinancing application volumes are at a two-year low and their share of all mortgage applications is the lowest since July 2019.

Fed officials are currently running the numbers on how long it could take for the mortgage holdings to run off the portfolio and no decisions have been made, Mester said.

But the Fed may want to address the possibility of asset sales early on when it starts to provide guidance on its plans for the balance sheet, Jones said.

“They’ll want to address the question in one way or another,” Jones said.

The MBS rundown – https://graphics.reuters.com/USA-FED/BALANCESHEET/mopanyrykva/chart.png

(Reporting by Jonnelle Marte and Howard Schneider; Editing by Dan Burns and Paul Simao)

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