Federal Reserve Chair Janet Yellen set a relatively high hurdle for shrinking the central bank’s balance sheet, leading some analysts to conclude that such a move won’t occur this year.
She told the Senate Banking Committee on Tuesday that the Fed’s focus was on raising interest rates to keep the economy in balance, and not on reducing its holdings of bonds.
Rates first need to reach sufficiently high levels that the Fed feels it has some room to cut them to offset a weakening economy. Only then would the central bank begin to shrink its $4.5 trillion balance sheet, she said.
“What we would like to do is to find a time when we judge that our need to provide substantial accommodation to the economy in the coming years is minimal,” she said. The central bank also wants to be sure “that the economy is on a solid course and the federal funds rate has reached levels where we have some ability to address weakness by cutting it,” she added.
Ward McCarthy, chief financial economist for Jefferies LLC in New York, said that this meant no move to start shrinking the balance sheet in 2017.
Policy makers expect to increase the fed funds rate to 1.4 percent by the end of 2017, according to the median of their projections released on Dec. 14. That would still leave it below the 20-year average of 2.3 percent.
The timing and scope of any moves to reduce the Fed’s debt holdings could have big implications for the bond market and for the economy as a whole. That’s because, as Yellen herself noted, they would represent an effective tightening of monetary policy.
“Allowing that process to take place,” Yellen said, “will show that the economy is doing well.”
The policy-setting Federal Open Market Committee has said it will continue to reinvest principal payments on the maturing bonds in its portfolio until “normalization of the level of the federal funds rate is well underway.”
Further Guidance