Explanation: Taper of the Federal Reserve: how does it work?

Nov. 3 (Reuters) – The U.S. Federal Reserve is expected to announce on Wednesday that it will start cutting its asset purchase program as early as this month, removing a first pillar of the emergency monetary policy accommodation introduced in March 2020 to protect the economy from the crisis. Covid pandemic19.

Here’s a guide on why and how the Fed is reducing this key element of its crisis support and what that means for the size of its future balance sheet.

WHAT IS THE FED ASSET PURCHASE PROGRAM?

The Fed has gobbled up trillions of treasury bills and mortgage-backed bonds since the start of the pandemic in a process known as quantitative easing to lower interest rates to long term, keep financial conditions flexible and help stimulate demand, similar to the playbook used after the 2007-2009 Financial Crisis and Recession.

It currently buys $ 80 billion in treasury bills and $ 40 billion in home-backed securities each month. Since the program began, the Fed’s balance sheet has swelled to $ 8.6 trillion from $ 4.4 trillion. An 8 trillion dollar reserve of treasury bills and MBS accounts for most of its total holdings.

WHY WILL IT BEGIN TO REDUCE THESE PURCHASES?

The economy, which is expected to grow this year at the fastest pace since the 1980s, no longer needs such extreme support measures and keeping them in place could do more harm than good. For example, low mortgage rates have fueled a surge in house prices, but the problems now plaguing the economy are mainly supply problems while demand, which the bond buys most directly, is dynamic and not shows no signs of sagging.

“They are doing it because the economy is really strong … The economy can fend for itself,” said Julia Coronado, former Fed economist and president of economic consultancy MacroPolicy Perspectives.

HOW DOES TAPERING WORK?

Most likely in mid-November, the Fed will begin each month to reduce the amount of purchases of Treasury securities by $ 10 billion and $ 5 billion of mortgage-backed securities, eliminating them completely by next June. . The Fed doesn’t stop bond buying all at once “to avoid shaking up the financial markets and sending (market) rates higher than they (naturally) would be,” said Kathy Bostjancic, Chief US Economist at Oxford Economics.

Officials said they expected the rollout to be on autopilot, but could speed up or slow the pace of procurement if necessary. The expected eight-month rate of reduction is also much faster than last time, a testament to the Fed’s confidence in the strongest recovery in decades and its desire to be able to hike rates. interest close to zero next year if inflation remains high.

WHAT NEXT FOR THE FED’S BALANCE SHEET POLICY?

By next June, the Fed’s balance sheet will reach just over $ 9 trillion, of which about $ 8 trillion will be bonds associated with several rounds of quantitative easing dating back to the financial crisis of last year. more than ten years. The question is what to do after that.

The last time around, the Fed started cutting its balance sheet two years after it started raising its primary short-term interest rate, also known as the federal funds rate, by not replacing securities as they mature. Fed watchers believe the central bank will also be patient and passive this time around, not least because it cut the balance sheet too much in 2018-19.

This resulted in a demand for bank reserves exceeding the Fed’s supply, causing volatility in money markets in the short term and a turnaround by the Fed, which was forced to increase its balance sheet again to improve the functioning of the markets. financial.

BUT IT WILL REDUCE HIS BALANCE SHEET, WON’T IT?

Not necessarily. Last time around, the Fed focused on shrinking its balance sheet because there was some discomfort with it as an untested policy tool. After using their balance sheet as the mainstay of their policy on two occasions since the Great Recession, “officials now understand that it will come out of the next recession and that it will be a tool in the toolbox,” Coronado said.

One option, already signaled by Fed Chairman Jerome Powell, would simply be to keep the balance sheet stable and let the economy grow there. As gross domestic product increased, the balance sheet would effectively shrink as a percentage of GDP, thus exerting less influence over time. The total toll as a percentage of nominal GDP is now almost 36%, roughly double what it was before the pandemic.

Others are not so sure, arguing that maintaining an overly large permanent balance sheet could limit its effectiveness in the next recession and could prompt the Fed to downsize again. “These numbers are important no matter how you think of them… There is reason to think about ‘normalizing’ some of these policy tools over time. sense that this will open up a greater scope to do more quantitative easing next time around, ”said Matthew Luzzetti, chief US economist at Deutsche Bank.

WHAT ARE FED POLICY MAKERS SAYING?

So far, few policymakers have weighed decisively. Last month, Fed Governor Christopher Waller called for a reduction in the balance sheet over the next two years by allowing maturing securities to step down, like last time. Kansas City Fed Chairman Esther George said in September that the Fed may want to keep long-term rates low by maintaining a large balance sheet, but counter that stimulus with a higher federal funds rate. That, however, could increase the risk of an inverted yield curve, an argument to shrink the balance sheet, also said George, perfectly illustrating the conundrum Fed officials face as they escalate discussions in the coming months.

Reporting by Lindsay Dunsmuir; Editing by Dan Burns and John Stonestreet

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