Wary of bond 'cliff,' Fed plans cautious cuts to portfolio

Thu May 7, 2015 12:12pm EDT
 
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By Jonathan Spicer and Ann Saphir

NEW YORK/SAN FRANCISCO (Reuters) - The Federal Reserve is sketching out plans to prevent an abrupt contraction in its massive balance sheet next year, when as much as $500 billion in bonds expire and risk disrupting markets and the U.S. economic recovery.

Though it ended a stimulative asset-purchase program last October, the Fed is still buying mortgage and Treasury bonds to replenish its $4.5-trillion portfolio as holdings mature. The central bank has said it will keep reinvesting until some time after it begins raising interest rates later this year.

Asked publicly and privately about the longer-term strategy, Fed policymakers say they are in no rush to shrink the portfolio, suggesting they will seek to avoid a "cliff" - a disruptive end to reinvestments that might come if bonds are simply allowed to run off through maturity or prepayment.

Economic analysis shows that shifting the end of reinvestments by several months in either direction would have "essentially no effect on the economic outlook," San Francisco Fed President John Williams told reporters last Friday.

"My view is this would happen organically," he added. But to avoid confusing investors with too many changes at once, he said, the Fed should give investors time to get used to rate increases before allowing the balance sheet to shrink. "You want enough separation in time just so that, once we get the (rate) normalization process going ... then this would be a decision that would be of second-order."

Six years of crisis-era purchases meant to boost economic growth quintupled the size of the Fed's balance sheet. The Fed predicts it will take until 2020 to shrink the portfolio back to normal.

The central bank can always sell bonds, but it said in September it will rely primarily on run-off to reduce holdings in a "gradual and predictable manner."

  Continued...

 
The United States Federal Reserve Board building is shown in Washington October 28, 2014.   REUTERS/Gary Cameron