The Federal Reserve’s balance sheet, which grew to $4.5 trillion as a result of several rounds of large-scale asset purchases, is much larger than is needed to support US reserve needs. With excess reserves of $2.5 trillion, its portfolio accounts for 20 percent of the long-term Treasury bond market and 25 percent of the market for mortgage-backed securities. Thus, the Fed’s substantial balance sheet and securities holdings still have an outsized influence over long-term interest rates. At its March meeting, the Federal Open Market Committee (FOMC) hinted that it might begin shrinking its balance sheet later this year. While this is part of the Fed’s plan to restore long-term interest rates to their natural equilibrium, many wonder how the market will respond.
In normal conditions, the Federal Reserve adjusts short-term interest rates to fulfill its dual mandate of full employment and stable prices. When there is excess slack in the labor market, the Fed pushes down short-term borrowing costs to spur private sector activity and encourage hiring. When inflationary pressure begins to build, it typically hikes interest rates to keep the economy from overheating.
But at the height of the Great Recession, near-zero short-term interest rates proved insufficient to promote growth. Thus, the Fed adopted an unconventional quantitative easing program—buying massive volumes of Treasury bonds and mortgage-backed securities in an attempt to drive down long-term borrowing costs and encourage private sector investment.
Quantitative easing was widely considered successful—long-term interest rates dropped, creating conditions for a gradual sustained recovery in the labor market. But now that full employment is on the horizon and the Fed is once again hiking short-term interest rates, these asset purchases need to be unwound to allow long-term borrowing costs to rise.
While the Fed plans to eventually return its excess holdings to the open market, its timeline for normalization is flexible. If the market shows a strong appetite for long-term securities, the Fed could sell off its excess holdings rapidly. In the most aggressive normalization scenario, the Fed could return $2.5 trillion in Treasurys and mortgage-backed securities to the market by 2021.
Alternatively, if private investors are unwilling to absorb such a large volume of assets, the FOMC could take a passive approach. Since economic growth naturally expands the monetary base, the Fed must hold an ever-increasing volume of reserves to backstop the US banking system. Currently, the Fed’s holdings are well in excess of the reserves level demanded by the financial sector, but that will change over time. If the Fed holds its balance sheet at current levels, its $4.5 trillion of reserves will become “normal” by 2030.
While the Fed controls the pace of normalization, it can’t directly influence the market’s reaction. Bond yields are set by supply and demand, and investor sentiment can move abruptly when conditions change. When the FOMC announced that it would taper its asset purchasing program in 2013, yields spiked in anticipation. The market’s reaction to normalization could follow a similar pattern, with investors driving up yields instantaneously, even if the balance sheet takes more than a decade to unwind.
Yields, and interest rates, are likely to rise on the dual forces of balance sheet normalization and the federal government’s growing structural deficit. As the population ages, the federal government will be forced to borrow more in the coming decades to make up for shortfalls in funding Medicare and Social Security obligations. Treasurys will need to offer higher yields to attract investors, especially as government debt increasingly competes with private sector borrowing.
Yields have recently vacillated with political developments, falling as the prospect of tax reform grows dimmer. But the longer-term forces acting on the market—normalization and increased public borrowing—promise a steepening yield curve in the years ahead.
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