Markets Unfazed as Federal Reserve Nears Plan to Shed Bonds


Stanley Fischer, the Fed’s vice chairman, offered the “tentative conclusion” in an April speech that “we appear less likely to face major market disturbances now than we did in the case of the taper tantrum,” the name often given to the sell-off in mid-2013.

The Fed, which held less than $900 billion in assets a decade ago, staged a series of bond-buying campaigns in the aftermath of the financial crisis, often described as quantitative easing. The Fed wanted to further reduce longer-term interest rates, but it had already lowered its benchmark interest rate to near zero.

Buying bonds reduced the supply available to investors, increasing competition so investors had to accept lower interest rates. The Fed, and some outside economists, argued that the purchases modestly reduced borrowing costs on mortgages and commercial loans, contributing to the gradual revival of economic activity.

The Fed estimated in an April analysis that its holdings reduce by about 1 percentage point the interest rate on the benchmark 10-year Treasury note, which is 2.2 percent.

Fed officials now say they expect to start reducing those holdings this year. The retreat is expected to reinforce the effects of the ongoing increases in its benchmark rate: higher borrowing costs for businesses and consumers, some outflow of money from the stock market into bonds, and some strengthening of the dollar.

Among outside economists, there is a range of views about the effects of the reduction. Some who doubted the benefits of the program expect the retreat to be similarly inconsequential. Others think the Fed’s analysis is in the ballpark. Still others worry that the Fed could roil financial markets.

The Fed does not plan to reduce its balance sheet to the precrisis level. The most basic reason is that demand for dollars has increased, and the Fed supplies that demand by purchasing securities. Currency in circulation has nearly doubled over the last decade, from $774 billion in May 2007 to $1.5 trillion last month. At the current rate of growth, the Fed projects currency in circulation would reach $2.8 trillion by 2027.

“It’s hard to see the balance sheet getting below a range of $2.5 to $3 trillion,” Jerome H. Powell, a member of the Fed’s board of governors, said in a recent speech to the Economic Club of New York.

The Fed also acquires securities to provide reserves to the banking system. Before the crisis, the Fed’s control of interest rates depended on keeping those reserves at a minimum level in normal times — on average, about $15 billion. But those balances soared in the aftermath of the crisis as the Fed pumped money into the financial system. Banks now hold about $2.2 trillion in reserves.

Moreover, the Fed has changed the mechanics of monetary policy so it can control interest rates without draining those reserves. And the new system is working: The Fed has successfully carried out three rate increases.

In his recent speech, Mr. Powell contrasted the Fed’s current approach, which he said “is simple to operate and has provided good control over the federal funds rate,” with the old system, which he described as complex and unwieldy.

He said the Fed had not decided whether to keep the new system. But his comments and those of other influential Fed officials have fostered an expectation that the Fed will maintain it. If the Fed does so, the level of reserves will remain above its precrisis level, and that means the Fed’s balance sheet will be larger, too.

In an April survey of two dozen Wall Street firms conducted by the Federal Reserve Bank of New York, the median estimate was that bank reserves would remain at roughly $688 billion in 2025 — and that the Fed’s balance sheet would sit at $3.1 trillion.

John C. Williams, president of the Federal Reserve Bank of San Francisco, said he still expected that in five years, the balance sheet would be “much smaller than today.”

But others think the reduction could end up being quite small.

“In a sense, the U.S. economy is ‘growing into’ the Fed’s $4.5 trillion balance sheet, reducing the need for rapid shrinkage over the next few years,” wrote Ben S. Bernanke, the former Fed chairman. Mr. Bernanke calculated that the Fed could need a balance sheet of roughly $4 trillion within 10 years.

The mechanics of the Fed’s retreat are more certain. The Fed plans to reduce its holdings without selling securities. That is possible because some of the securities mature each month.

Analysts estimate about $280 billion in securities will mature during the remainder of 2017, and another $650 billion will mature during 2018.

By gradually reducing the amount it reinvests each month, the Fed can gradually reduce its investments while avoiding potentially disruptive sales.

Some analysts expect the Fed to wait until December; some say September. There is also a range of predictions about the pace of the retreat.

The Fed said in May, in an account of its most recent policy meeting, that it expected to publish a schedule for the entire process. It will reduce purchases by the same amount for three months, and then increase that cap each quarter.

The plan is orderly on paper, but it assumes the continuation of what is already an unusually lengthy economic expansion. If the economy weakens, the Fed could pause.

It might even see the need to once again expand its balance sheet.

Correction: June 12, 2017

An earlier version of this article misstated the Federal Reserve’s projection of the amount of currency in circulation by 2027. At the current rate of growth, the Fed projects the currency in circulation will reach $2.8 trillion, not billion.

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