In case exiting years of zero interest rates won’t be hard enough, Federal Reserve officials have another challenge approaching quickly: when to begin unwinding trillions of dollars of bond purchases that constitute the world’s largest fixed-income portfolio.

Less than a year from now, the Fed must decide whether to reinvest $216 billion of proceeds from Treasury debt maturing in 2016, or shrink its balance sheet by allowing it to expire. By not reinvesting, the Fed would increase the supply of securities available to investors and put upward pressure on yields.

Shrinking the $4.2 trillion portfolio will add to the monetary tightening from increases in the benchmark interest rate officials envision for this year. That would mark a reversal of the easing the Fed achieved when it bought bonds to speed a recovery from the worst recession since the 1930s.

The timing will be tricky. Fed Chair Janet Yellen, concerned the economy remains fragile, has said the pace of rate increases is likely to be gradual and cautious. A decision to start unwinding the Fed’s bond portfolio could give her more reason to proceed slowly or even stop raising rates for a time, said Drew Matus, deputy U.S. chief economist at UBS Securities LLC in New York.

“From an economist’s perspective, you kind of want one thing happening at a time,” said Matus, a former analyst on the New York Fed’s open-market desk. “Our baseline view is that they keep the pace of rate hikes slow as they are moving toward and into the initial roll-off period, but it’s also possible that becomes a great time for them to pause for six months.”

Zero Rates

The Fed started its unprecedented bond purchases to reduce longer-term borrowing costs after cutting the benchmark federal funds rate almost to zero in December 2008. The central bank bought Treasuries and mortgage debt in three waves of so-called quantitative easing that ended in October 2014.

Officials have said they will probably never sell mortgage debt outright, and they haven’t decided whether to sell Treasuries. They will allow their portfolio to shrink “in a gradual and predictable manner,” mainly by ceasing reinvestments and allowing the portfolio to run off over time as securities mature, according to a September statement.

“When the FOMC chooses to cease reinvestments, the balance sheet will naturally contract,” Vice Chairman Stanley Fischer said in a March 23 speech in New York. “This runoff of our securities holdings will also gradually remove accommodation, an effect that we will need to take into account in setting the stance of policy.”

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