Friday, May 21, 2010

April’s FOMC Minutes on Strategies to Unwind Fed’s Balance Sheet

Although the Federal Open Market Committee (FOMC) made no decision about its longer-term strategy of asset sales and redemptions, the minutes of the April 27-28 FOMC meeting provide some interesting insights into the thinking of the FOMC regarding the future contraction of the Federal Reserve’s balance sheet. The FOMC for now has agreed to continue the current approach of allowing all maturing agency debt and all prepayments of agency mortgage-backed securities (MBS) to be redeemed without replacement while rolling over all maturing Treasury securities.

However, according to the minutes, “most participants expressed a preference for strategies that would eventually entail sales of agency debt and MBS in order to return the size and composition of the Federal Reserve’s balance sheet to a more normal configuration more quickly than would be accomplished by simply letting MBS and agency securities run off.” From March to the end of 2011, the New York Fed projected that more than $200 billion of the agency debt and MBS in its portfolio would mature or be prepaid. Further, $140 billion of Treasury securities are set to mature between March and 2011. Yet, some FOMC members believe the pace of unwinding the Fed’s balance sheet should be accelerated. In general, FOMC participants felt that the sales of agency debt and MBS should be communicated in advance and be conducted at a gradual pace, but would be adjusted to changing economic and financial conditions.

There was a wide range of views regarding asset sales strategies. Most felt any asset sales should wait for some time with a majority believing it should come some time after the FOMC’s first increase in its target short-term interest rate. This approach would delay any asset sales until after the economic recovery was on firm footing and would keep short-term interest rates as the key policy tool for monetary policy.

Others supported an approach where a general schedule for asset sales would be announced soon. They did not believe that the sale of assets needed to be tied increase in its target short-term interest rate.

A few participants at the FOMC meeting wanted asset sales to begin soon. Their rationale was that earlier sales of assets would cause a quicker normalization in the size and composition of the Federal Reserve’s balance sheet. This would partially unwind the unconventional policy stimulus that was put in place during the financial crisis. They also wanted to see this done before conventional policy firming got underway.

While communicating the pace of asset sales would limit market disruptions, views differed on the pace of sales. Most believed that the agency debt and MBS held in the portfolio should be sold at a gradual pace and that the sales should be completed about five years after they began. A possible variant of this strategy would be to start sales slowly and increase the pace over time. This would give markets time to adjust.

A couple of participants thought the pace of sales should be faster, completed in about 3 years. They did not believe the faster pace of sales would put undue strain on the financial markets. They viewed a more rapid contraction in the Fed’s balance sheet would lower the probability “that the elevated size of the Federal Reserve’s balance sheet and the associated high level of reserve balances could raise inflation expectations and inflation beyond levels consistent with price stability or could generate excessive growth of credit when the economy and banking system recover more fully.”

As for Treasury securities, the FOMC saw advantages and disadvantages associated with not rolling over the debt as it matures. Redeeming Treasury securities would contribute to a more expeditious normalization of the size of the balance sheet and the quantity of reserves. However, it could put upward pressure on interest rates and work against the objective of returning the Systems Open Market Account back to strictly Treasury debt.

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