More than a decade after it all began, the Federal Reserve is finally nearing the end of its grand experiment in monetary policy.
The Fed, which has been paring its crisis-era debt holdings, may lay out plans to end the program at its meeting next week. Yet in the Treasury market, the close of the quantitative-easing era could open another can of worms.
While Fed officials have made it clear they want to go back to owning mostly Treasuries, as they did before the financial crisis, it’s unclear how the central bank will get there or what it will buy. Its current policy, replacing mortgage bonds only when they mature, could take a decade or more. That’s led some to advocate outright sales, which the Fed has never done. Then, there’s the debate over whether the central bank will favor short-term Treasuries over long-term debt, or simply buy whatever the U.S. Treasury auctions off.
“People are way too focused on when the Fed is going to end the balance-sheet shrinkage,” said William Dudley, former head of the New York Fed, who is now a professor at Princeton University. “That question is actually pretty trivial relative to the question of what is the Fed’s balance sheet going to look like over the long run.”
The consequences could ripple through the bond market and beyond. Decisions affecting the composition of the Fed’s balance-sheet assets will not only create winners and losers across financial markets, but could also go a long way to help the U.S. government finance its burgeoning budget deficit.
Currently, the Fed holds just a little less than $4 trillion in assets and is paring its bond holdings by a maximum of $50 billion a month. Bond dealers expect the Fed to end its runoff by December, which will leave it with roughly $3.5 trillion to $3.7 trillion in assets.
One important thing to understand is that the Fed needs to continually add Treasuries to replace those that come due just to keep the size of its balance sheet constant. That means it will need to ramp up purchases even more as it shifts away from mortgage bonds. (As an aside, analysts also see the Fed’s balance-sheet assets gradually starting to grow again in a year or so. If they don’t, the steady rise of dollars in circulation on the liability side of the ledger will squeeze bank reserves, which have already fallen in recent years.)
Two Ways
The Fed reinvests money from its maturing debt holdings in two ways. When replacing Treasuries, it participates in so-called auction add-ons, which enable the central bank to purchase debt alongside the public to finance U.S. government spending. So, the more debt the Fed gobbles up, the less money the U.S. Treasury needs to raise at auction. When replacing MBS, it buys debt directly from investors in the open market (more on that later).
For many bond dealers, the Fed’s Treasury purchases at auction will help the government scale back bill issuance. Citigroup also predicts 2-to-5-year note auctions will shrink later this year as a consequence of increased Fed demand.
“The most important impact for the bond market will be that the Treasury’s net marketable borrowing needs from the public will decline,” said Margaret Kerins, global head of fixed-income strategy at BMO Capital Markets.