January 8, 2016 / 12:45 AM / 2 years ago

Fed leans on big balance sheet to soften rate hike impact

Traders work on the floor of the New York Stock Exchange (NYSE) shortly after the announcement that the U.S. Federal Reserve had hiked interest rates for the first time in nearly a decade in New York, December 16, 2015. .Lucas Jackson

SAN FRANCISCO (Reuters) - Federal Reserve policymakers appear to have succeeded in their push last month to convince investors the central bank will hold on to its $4.5-trillion portfolio at least until next year, a Fed survey showed on Thursday. 

Recent interviews with officials showed they were counting on the Fed's massive bond holdings to blunt some of the impact of interest-rate hikes this year. But they were also concerned that markets did not fully appreciate that the central bank was willing to hang on to the bonds for longer than thought only three or six months ago.

They said that apparent perception gap could explain in part why they are expecting a brisker series of rate hikes in 2016 than investors do. It was also a reason why, as it raised rates last month for the first time in nearly a decade, the U.S. central bank used new language saying it will keep its portfolio at its record size until rate hikes are "well under way."

The nudge, designed to push back expectations when the Fed would start shrinking its giant portfolio, seems to have worked.

The New York Fed's survey published on Thursday showed that before last month's rate hike most Wall Street dealers had expected the balance sheet to start shrinking around December.

But canvassed again on Dec. 18 most forecast the Fed would keep its $2.5 trillion Treasuries portfolio intact until March of next year, and its nearly $2 trillion mortgage-backed securities until January of 2017.

San Francisco Fed President John Williams told Reuters that by holding long-term borrowing costs down, the Fed's giant portfolio should give it some more headroom to raise rates without accidentally triggering an economic slowdown.

EXTRA LEEWAY

Williams said that tightening at a brisker pace allows more leeway to cut rates should the recovery go sour, rather than relying on the "cumbersome" tool of quantitative easing if rates were still near zero.

"If we get that negative shock, we get a little bit of a cushion ... and of course we can adjust (rates) as needed," he said in an interview on Dec. 18.

The Fed is currently reinvesting proceeds from maturing assets, under a long-held plan. Doing so for even a few months longer than markets expect could depress longer-term borrowing costs and offset the planned tightening in short-term rates. (Graphic: link.reuters.com/myp55v)

This faith in the ongoing stimulative effect of the giant portfolio, built up from $900 billion to boost the U.S. recovery from recession, could be tested if world financial markets continue to tumble as China's economy slows.

But for the time being, Williams and most other Fed policymakers continue to see four rate hikes this year.

"I would feel better if we could get a few more rate increases and not have to worry about the balance sheet," Cleveland Fed President Loretta Mester told Reuters in an interview earlier this week. "There's no compelling reason now to shrink the balance sheet."

Richard Moody, chief economist for Regions Bank said the sheer size of the Fed's balance sheet and the amounts to be reinvested meant maintaining the portfolio would likely have an impact.

"This can, and I think will, have a dampening effect on any increase in longer term rates as the Fed raises the funds rate."

Markets are more skeptical. Traders are betting on two or possibly three hikes in 2016, based on rate futures markets. Economists surveyed by the New York Fed see three hikes this year.

Short-term U.S. rate futures have risen in recent days in response to the selloff sparked by weakness in China and Beijing's moves to weaken the yuan, and to dovish minutes from the Fed's December meeting.

Yet Fed officials have so far taken a wait-and-see approach, with some of the hawks even hinting at more than four rate hikes this year. Markets are "underestimating" where rates are going to be, Fed Vice Chair Stanley Fischer said on CNBC on Wednesday.

Reporting by Jonathan Spicer and Ann Saphir; Editing by Tomasz Janowski

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