Washington - Federal Reserve Chair Janet Yellen set a
relatively high hurdle for shrinking the central bank’s balance sheet, leading
some analysts to conclude that such a move won’t occur this year.
She told the Senate Banking Committee on Tuesday that the
Fed’s focus was on raising interest rates to keep the economy in balance, and
not on reducing its holdings of bonds.
Rates first need to reach sufficiently high levels that
the Fed feels it has some room to cut them to offset a weakening economy. Only
then would the central bank begin to shrink its $4.5 trillion balance sheet,
she said.
“What we would like to do is to find a time when we judge
that our need to provide substantial accommodation to the economy in the coming
years is minimal,” she said. The central bank also wants to be sure “that the
economy is on a solid course and the federal funds rate has reached levels
where we have some ability to address weakness by cutting it,” she added.
Ward McCarthy, chief financial economist for Jefferies in
New York, said that this meant no move to start shrinking the balance sheet in
2017.
Policy makers expect to increase the fed funds rate to
1.4 percent by the end of 2017, according to the median of their projections
released on Dec. 14. That would still leave it below the 20-year average of 2.3
percent.
The timing and scope of any moves to reduce the Fed’s
debt holdings could have big implications for the bond market and for the
economy as a whole. That’s because, as Yellen herself noted, they would
represent an effective tightening of monetary policy.
“Allowing that process to take place,” Yellen said, “will
show that the economy is doing well.”
The policy-setting Federal Open Market Committee has said
it will continue to reinvest principal payments on the maturing bonds in its
portfolio until “normalization of the level of the federal funds rate is well
underway.”
Further guidance
Yellen told the lawmakers Tuesday that the FOMC will
discuss that strategy “in the coming months” with the aim of providing
investors with “some further guidance” about its intentions.
The central bank will want to telegraph its plans well
advance of their implementation so as to avoid upsetting financial markets,
said Michael Feroli, chief US economist at JPMorgan Chase & Co in New York.
He expects policy makers to do that in the second half of
this year. The process of halting reinvestments though won’t begin until the
middle of next year, according to Feroli.
Yellen rejected recent suggestions by several Fed bank
presidents that the central bank use its balance sheet as an active tool of
monetary policy. Instead, the focus will remain on managing the fed funds rate
in response to changes in the economy.
The Fed chair also said that the reduction in the Fed’s
bond portfolio would occur in a “gradual and orderly way.”
Gradual taper
That’s similar to the strategy the central bank employed
when it tapered its asset purchases in 2014, reducing them in set amounts at
each policy-making meeting.
More than $600 billion in Treasury securities in the
Fed’s portfolio are scheduled to mature this year and next, according to
calculations by Bloomberg.
Yellen’s four-year term as Fed chair expires on February
3, 2018, and she repeated that she has no plans to leave the central bank
before then.
McCarthy said the next Fed chair might well take a more
aggressive approach to reducing the balance sheet, although Feroli said it
might be difficult to change the Fed’s strategy once it has been put into place
and digested by the markets.
Yellen told lawmakers that she expects the central bank
to eventually end up with “a balance sheet that’s substantially smaller than at
the current time.”
“In addition, we would like our balance sheet to again be
primarily Treasury securities,” she said. Besides Treasuries, the Fed portfolio
also contains mortgage-backed debt and agency securities issued by Fannie Mae
and Freddie Mac.
There’s a limit to how far the balance sheet can be
reduced, however. At a minimum, it needs to be big enough to cover the roughly
$1.5 trillion in currency now in circulation, which is increasing every year.