The Federal Reserve is tapering its innovative bond-buying program ahead of an expected yearend conclusion. This is a welcome step toward the normalization of interest rates.
The Fed, as expected at its June Federal Open Market Committee meeting, reduced its monthly bond purchases by another $10 billion, to $35 billion, consisting of $15 billion in mortgage backed securities and $20 billion in U.S. Treasuries. That makes five straight FOMC meetings that lessened its monthly asset purchases by $10 billion, from the original $85 billion in bond purchases when Ben S. Bernanke was Chairman of the Federal Reserve.
Now it is Janet Yellen as Fed Chair that has the program lined up to be concluded later this year. The winding down is a good thing since, while generally considered a success, it cannot go on forever without creating side effects, such as inflation. It doesn’t seem wise, either, to allow the Fed’s balance sheet to expand in an uninterrupted manner. A $4 trillion asset base following a financial crisis is one thing, but to potentially get to a $5 trillion or $6 trillion balance sheet when business conditions are close to normal is quite another matter. Of course, the Fed is making sure the economic recovery is deep-rooted, but even the Fed knows that it would be in its best long-term interests to have an uncluttered balance sheet. That would allow it to fully and more forcefully respond to any future crises.
There is also the related policy of keeping interest rates so low as to hurt savers, many of whom are senior citizens. There are an estimated 40 million people age 65 and over in the United States. A great number of them have seen their income from certificates of deposits and money market funds substantially reduced in recent years.
Overall, the Federal Reserve’s balance sheet now stands at $4.4 trillion, up a very sizable $3.5 trillion since before the severe 2007-2009 recession began. With four FOMC meetings left to go in 2014, it is highly likely the Fed’s asset purchasing program will be history by the time 2015 rolls around. That is unless there is an unforeseen slowdown in the economy or some sort of international crisis were to shock the investment community.
What stands out now is that we are in a transition period, dialing back from maximum monetary stimulus, heading toward a neutral stance by the Fed, prior to an eventual tightening of monetary policy. The central bank is changing course extremely slowly and being highly transparent so as not to rattle the financial markets.
But the central bank is essentially in unchartered waters, and it got there because its normal tools were insufficient to handle the magnitude of the problems presented by the last financial crisis. That could mean the Fed’s tools will be less effective than usual, or create distortions, as policy makers look to get back to business as usual.
For instance, it will presumably take a number of years for the Federal Reserve to sell all of the securities it has purchased (and is still buying). It certainly would be a tall order to try and sell $4 trillion of bonds at once. Basically, the Fed will need to unload its portfolio of Treasuries and mortgage-backed securities extremely slowly in order not to send the bond market into disarray. Meanwhile, a certain percentage of the Fed’s holdings will mature on their own.
First, though, the Federal Reserve needs to stop buying securities before it can shrink its balance sheet. At least the central bank’s slowdown in bond purchases brings it closer to a normal course of action where there is less chance of complications down the road.
For investors looking to capitalize on the likelihood of higher long-term interest rates as the Fed’s bond-buying winds down, shares of financial companies, such as MetLife (MET) and Bank of America (BAC) stand to enjoy improved margins and, quite possibly, more favorable sentiment.
At the time of this article, the author did not have positions in any of the companies mentioned.