The Federal Reserve pumped more than $1 trillion dollars into the economy at a lightning pace, but it plans to take it out glacially, a senior Fed official said in a speech Monday.
Brian Sack, who runs the markets group at the Federal Reserve Bank of New York, laid out more detail on the Feds plans to reduce its massive holdings of mortgage backed securities and Treasurys in a speech to the National Association of Business Economics in Washington.
The Fed is on course to own more than $1.25 trillion worth of mortgage backed securities by the end of March. As the economy improves it wants to reduce those holdings, but officials dont want to do it in a jarring way. Mr. Sack noted that some of these holdings will run off naturally. By the end of 2011, more than $200 billion worth of mortgage securities mature or will be prepaid by borrowers. The Fed can shrink its balance sheet by not reinvesting proceeds from these securities as theyre paid off by borrowers, helping its own balance sheet to “shrink meaningfully.
Mr. Sack noted that another $140 billion worth of Treasury securities mature by the end of 2011. Right now the Fed is reinvesting cash it gets as Treasury securities mature, but it could decide to let those securities run off too, shrinking its balance sheet even more, he noted.
With this approach, the FOMC would be shrinking its balance sheet in a gradual and passive manner, he said. That, in my view, is a crucial message for the markets.
A decision to shrink the balance sheet more aggressively could be disruptive to market functioning, he said, adding, A more aggressive approach would risk an immediate and substantial rise in longer-term yields that, at this time, would be counterproductive for achieving the (Feds economic growth) objectives.
Mr. Sack also offered noteworthy insights into how the Fed believes markets are positioning for possible interest rate increases in the months ahead.
The current configuration of yields and asset prices incorporates expectations that short-term interest rates will begin to rise around the end of this year, he noted. Thus, the markets seem prepared for the risks toward tighter policy.
Mr. Sack doesnt make decisions about interest rates, but he does give Fed decision makers important guidance on how they can expect markets to react if the Fed moves rates higher. The message here seems to be that markets wouldnt be jolted if rate hikes come later in the year.
Looking out to longer maturities, the shape of the Treasury yield curve appears to incorporate not only expectations of policy tightening, but a decent-sized term premium on longer-term securities, he noted.
Indeed, the term premium is well above the levels observed over most of the past several years, even though inflation is likely to be low and upside inflation risks are limited. This should help to diminish the chances of a sizable upward shift in yields.
Translation: Dont expect long-term yields to shoot higher if the Fed nudges short-term rates up.