The Federal Reserve Board has issued an addendum to its “Policy Normalization Principles and Plans” for reducing its bulked up $4.5 trillion portfolio, but there’s nothing normal about unloading $4.5 trillion in bonds.
The Fed’s policy, which virtually no one has read since it was issued in November 2014, is an update of its 2011 normalization policy, which no one read. It crams quite a few words into a single page, which we would summarize by saying that the Fed hopes to unload as much of its bond holdings as it can without causing the bond market to collapse.
Fed Will “Cease or Commence”
In case you don’t believe me, here’s a sample paragraph: “The (Federal Open Market Committee) expects to cease or commence phasing out reinvestments after it begins increasing the target range for the federal funds rate; the timing will depend on how economic and financial conditions and the economic outlook evolve.”
Note the “cease or commence.” In other words, the Fed will either stop buying bonds to keep its portfolio close to $4.5 trillion or it won’t. Talk about commitment issues!
The latest addendum is the second issued by the Fed. The first, which no one read, was issued on March 18, 2015. It’s just a few paragraphs, but it’s not for the ADD-inflicted. For example, it says, the Fed will: “Allow aggregate capacity of the ON RRP facility to be temporarily elevated to support policy implementation; adjust the IOER rate and the parameters of the ON RRP facility, and use other tools such as term operations, as necessary for appropriate monetary control, based on policymakers’ assessments of the efficacy and costs of their tools.”
Good to know. An ON RRP facility, by the way, is an overnight reverse repurchase agreement facility (imagine the signage on that building!). And for those considering a career in banking, the IOER rate is the interest rate on excess reserves.
The latest addendum is at least clearer. It says it will reinvest only the principal payments it receives that exceed a cap that is initially set at $6 billion a month. The cap will gradually rise to $30 billion, increasing by $6 billion a quarter for a year.
For holdings of agency debt and mortgage-backed securities, the FOMC “anticipates” (see above, re: commitment issues) that the cap will start at $4 billion a month and increase by $4 billion a quarter until it reaches $20 billion.
The FOMC “anticipates” that the caps will remain in place at the $30 billion and $20 billion level “so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”
When and How Much?
Two significant questions remain unanswered by the Fed: 1. When it will begin normalization and 2. At what point it will stop; that is, will the portfolio be in the trillions of dollars or hundreds of billions of dollars, as it was before the financial crisis.
While it’s not clear how far the Fed will draw down its balance sheet before it completes its normalization process, at the end it will have a balance sheet “appreciably below that seen in recent years but larger than before the financial crisis,” according to the Fed, because banks are holding higher reserves at the Fed than before the financial crisis.
“This is a pretty broad end point,” according to Business Insider, “given that the Fed held roughly $800 billion in assets before the financial crisis and $4.5 trillion now.”
When the Fed will begin normalization also isn’t all that specific, although at each of its last two meetings it expressed a desire to begin the process this year, “provided that the economy evolves broadly as anticipated.” (Do you get the feeling the Fed is run by attorneys?)
What impact normalization will have on the bond market, even if it takes the frog-in-boiling-water approach, is difficult to fathom, given that no one has ever tried to dump trillions of dollars’ worth of bonds on the market.
For perspective, consider that the U.S. bond market is valued at about $40 trillion, while the stock market is valued at less than half that amount. Normalization by the Fed could still have a major impact, but the process is likely to pause at the first sign of a bond bubble.
New Chair Being Appointed
Of course, the current normalization process may give way to a new normal, as President Trump has an opportunity to significantly change the make-up of the Fed.
While Chair Janet Yellen’s term doesn’t expire until January, he has appointed Gary Cohn, his chief economic advisor and former president of Goldman Sachs, to manage the search process. But he also has three vacancies to fill, in addition to replacing the general counsel.
Will he reappoint Ms. Yellen? Will be fill the board with hardliners who will expedite normalization? The only thing you can predict about President Trump is that he will do the unpredictable. Just follow the tweets.
“Now, Gary’s going to have some fun with this, giving some grundle time to the Yellens and Neel Kashkaris of the world,” according to Dealbreaker. “But eventually he’s going to have to tell Trump whose name to send up to the Hill. And who better than a three-decade Wall Street veteran who also happens to be the president’s ablest and most loyal economic adviser?”