Active Stocks
Thu Mar 28 2024 15:59:33
  1. Tata Steel share price
  2. 155.90 2.00%
  1. ICICI Bank share price
  2. 1,095.75 1.08%
  1. HDFC Bank share price
  2. 1,448.20 0.52%
  1. ITC share price
  2. 428.55 0.13%
  1. Power Grid Corporation Of India share price
  2. 277.05 2.21%
Business News/ News / World/  US Federal Reserve ponders how to do the big unwind
BackBack

US Federal Reserve ponders how to do the big unwind

Fed Chair Janet Yellen says the central bank shouldn't begin until it's confident that the economy is on a solid course and no longer needs substantial help

US Federal Reserve Chair Janet Yellen. Photo: BloombergPremium
US Federal Reserve Chair Janet Yellen. Photo: Bloomberg

The US Federal Reserve helped pull the country’s economy from the brink of disaster by purchasing vast quantities of government bonds and mortgage-backed securities. That rescue, known as quantitative easing, was designed to promote economic growth by keeping long-term interest rates low, but it also pumped up the assets on the Fed’s balance sheet to an unheard-of $4.5 trillion. The Fed stopped its buying spree in 2014, but purposely refrained from paring its bloated balance sheet until it was sure the economy was good and ready. Now, with the Fed pushing short-term interest rates back up toward normal, that moment is approaching. It will probably be widely signalled, but that doesn’t mean it won’t be messy.

1. What’s the big deal?

At $4.5 trillion, the Fed’s balance sheet is equivalent to about a quarter of America’s annual gross domestic product. By holding down yields on Treasury securities and mortgage-backed debt, the Fed made it cheaper for the US government to finance its budget deficits and for home buyers to take out a loan. It reduced costs for companies in China and other emerging markets that borrow in dollars. It also had important implications for financial markets. The Fed’s purchases made US Treasury securities more expensive, thus encouraging investors to buy stocks instead. This way, the Fed has helped fuel the huge run-up in equity prices since 2009.

2. So what could go wrong?

Shrinking the balance sheet is another way of tightening. Some analysts say it could have an even bigger effect on the US and global economies than raising short-term interest rates. The fear is that the Fed will remove an important prop for the economy and for financial markets.

ALSO READ | Can’t recall a hawkish Fed? Bet the taper’s still fresh

3. Has this ever been done before?

No. That’s why investors and borrowers don’t know what to expect. But the portents aren’t particularly good: When then-Fed chairman Ben Bernanke suggested in May 2013 that the central bank was just considering scaling back its bond purchases, financial markets took fright. The subsequent rise in long-term interest rates hit the US housing industry and emerging markets hard. The fallout was significant enough to earn a sobriquet in the financial markets: the taper tantrum.

4. When will the unwinding begin?

Not for months. Fed Chair Janet Yellen has said the central bank shouldn’t begin until it’s confident that the economy is on a solid course and no longer needs substantial help. She also wants to raise short-term interest rates further from zero before taking action on the balance sheet. Bernanke told investors in March that he didn’t expect those requirements to be met until early next year. But Philadelphia Federal Reserve Bank president Patrick Harker has said the Fed should seriously consider letting the balance sheet run down once its benchmark interest rate hits 1%, which could be soon.

5. If it’s so risky, why is the Fed even considering it?

Some Fed officials worry that its big bond holdings are causing distortions in the financial markets, prompting investors to take on more risks than they should. Others are concerned that the central bank is favouring the housing industry over the rest of the economy by keeping mortgage-backed securities in its portfolio. But an unspoken reason for acting is political. Republican lawmakers were sharply critical of the Fed’s quantitative easing programs, charging that the central bank was making it easier for former president Barack Obama to run big budget deficits. By reducing the balance sheet, Fed insiders are hoping to defuse some of that criticism and protect the central bank’s political independence.

ALSO READ | Inflation accelerates before Fed review; spurs RBI concerns

6. Can the Fed minimize the fallout?

It hopes so. First, it will likely announce a strategy well before any reduction begins to give investors time to adjust. Second, it won’t sell any of its mortgage-backed securities, thus limiting the effect on the housing market. And third, it will avoid outright sales of Treasury securities, at least at the start. Instead, it will pare its portfolio by allowing bonds to “roll off," which means effectively pocketing, rather than reinvesting, the proceeds of bonds as they mature. (The Fed currently reinvests those proceeds by buying more bonds.)

ALSO READ | US stocks fall as oil drops to lowest since November

7. How long will all this take?

Bernanke has said the whole process could take five to seven years, further limiting its effect. One worry with this approach is that about a third of the Fed’s Treasury portfolio, or about $785 billion worth, comes due in 2018 and 2019. Of course, the strategy could change under a new Fed leader. Yellen’s four-year term as chair expires in February 2018, and it’s widely expected that President Donald Trump won’t ask her to stay in the top spot.

8. What’s in the Fed’s portfolio, anyway?

The central bank owns about $2.5 trillion in US Treasury securities. That’s equivalent to about 15% of the government debt held by the public. Its holdings of mortgage-backed securities total about $1.7 trillion, representing more than a quarter of that market. The rest of its $4.5 trillion portfolio consists of such assets as swaps with foreign central banks, overnight loans of securities and foreign currencies.

Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 15 Mar 2017, 01:55 AM IST
Next Story footLogo
Recommended For You
Switch to the Mint app for fast and personalized news - Get App