1 December 2017
The Federal Reserve initiated in October2017 the unwinding of its securities holdings acquired as a result of its quantitative easing policy. It means channelling large amounts of credit and duration risk back into the market. At the same time, the collapse of money velocity highlights persistent strong liquidity preference by the market and likely wariness to absorb interest rate risk in an environment of targeted interest rate increases. The combination of low money velocity and long duration of the Fed’s balance sheet means that unwinding of quantitative easing will be a complicated affair. At the end of targeted normalisation, the Fed will still retain unprecedented large amounts of rate and credit risks. The Fed could therefore become itself an important source of instability for monetary policy, the international monetary system and the dollar.
The Fed’s quantitative easing was accompanied by a sustained fall of money velocity. The decline of money velocity, the ratio of quarterly GDP by broad money (M2), indicates a significant shift in liquidity preferences and remains one of the most important consequences of the Fed's policy interventions. The purchase of long dated assets by the Fed has induced an intended decline in long-dated bond yields. In turn, it has reduced the opportunity cost of cash, that is, the yield forgone by holding cash instead of investing in bonds and receiving interest, thus reinforcing low money velocity. The low money velocity greatly complicates monetary policy as it undermines the effect of any monetary stimulus as the decline in velocity offsets any monetary expansion and vice versa.
The Fed’s large asset purchases have increased its holdings of Treasury and Agency mortgage-back securities from an average of US$725 billion in 2003-07 to US$4,235 billion today. The Fed’s balance sheet increased from US$842 billion in 2003-2007 (6.5 percent of GDP) to US$4,517 billion (23.3 percent of GDP). Nominated Fed chairman Jerome Powell now indicated that he foresees the Fed’s balance sheet to shrink to about US$2.5 to US$3.0 trillion (11.3-13.2 percent of GDP) and take about 3-4 years or by December-2020-September 2021.1
The Fed’s security holdings have an average life of 15.1 years in November 2017, of which Treasury securities have 7.8 years and MBS 25.1 years, compared with an average life of its security holdings of 3.4 years in 2003-07.2 While in 2003-07, on average 53 percent of all Treasury securities held by the Fed had a remaining average life of less than 1 year, in October 2017 only 17 percent had (Table). At end-October, the Fed held 20 percent of all treasury securities outstanding with a remaining life of more than 1 year and 33 percent of treasury securities with a remaining life of more than 10 years.
The Fed’s normalisation policy approach contemplates a gradual shrinking by US$30 billion per month in Treasury securities and US$20 billion per month in MBS.3 Assuming the Fed returns to a balance sheet, whereby federal debt remains in proportion to total assets as of today, the Fed would retain about US$2.3-US$2.8 trillion in Federal debt. While the Fed did not hold any MBS prior to 2009, about 40 percent of Federal debt held by the Fed today consists of MBS. A Fed balance sheet of US$2.5-US$3.0 trillion would imply a shrinking by about US$1.7 trillion in federal debt and retaining holdings of US$1.3-US$1.6 trillion of Treasury securities and US$1.0-1.2 trillion of MBS at the end of normalisation.
The Fed holds US$1.5 trillion in Treasury securities and US$0.1 trillion of MBS maturing within 5 years. Given the normalisation schedule, the Fed could reduce its Treasury security holdings largely by simply allowing notes and bonds to be redeemed. However, given that the Fed had historically maintained Treasury holdings mostly in shorter maturities, it seems more likely that the Fed will predominantly reduce holdings in longer dated securities. Assuming the Fed would return to the pre-2008 maturity distribution of its Treasury securities holdings, the Fed would reduce to 40 percent of its current holdings of Treasury securities maturing within 1 to 10 years and to 20 percent of its holdings maturing in over 10 years (Chart 2). The reduction of MBS holdings would imply selling MBS mostly with a remaining life of more than 10 years. The Fed’s normalisation path implies the reduction of assets by US$1.7 trillion in 2018-21 compared with redemptions due of US$1.3 trillion in 2018-21 (Chart 3). The redemption profile of the Fed implies that the Fed will sell large amounts of long-dated assets as part of normalisation and possibly repurchase shorter-dated assets.
The actual normalisation path will likely depend on the Fed’s view of how to share duration, credit and yield curve risk with the market. The combination of low money velocity and potential large injections of duration and credit risk into the market may greatly complicate the unwinding of the Fed’s balance sheet. The possible rebalancing towards shorter-dated securities could also significantly affect the slope of the yield curve with corresponding important financial stability implications. The collapse of money velocity benefitted commercial banks and a reversal may imply important funding constraints for banks.
The Fed’s greatest challenge in normalisation lies naturally in shifting duration and credit risk back into the market without causing undue volatility in long-dated assets. The Fed became one of the main pools for Treasury securities duration. The unwinding of about US$1.7 trillion in Treasury securities and MBS corresponds to a major redistribution of duration and credit risk. This poses important challenges for the price formation of fixed income securities, currencies and monetary stability conditions. Under most scenarios, the Fed will maintain a large exposure to interest rate and credit risks. This may in itself greatly complicate implementation and effect of monetary policy as the Fed’s balance sheet will retain a large exposure to its own policy. Furthermore, any reversal in money velocity could mean a significant strong monetary stimulus when the Fed is aiming for monetary tightening. Naturally, the orderly unwinding of the effects of unconventional monetary policy will be the key test to gauge if large-scale quantitative easing actually represents a feasible monetary policy approach.
1 Financial Times, “Powell sees Fed balance sheet shrinking to $2.5tn-$3tn,” 28 November 2017. GDP projection is by IMF for 2021.
2 New York Federal Reserve Bank SOMA, 22 November 2017 and 21 November 2007, 22 November 2006, 23 November 2005, 24 November 2004, 19 November 2003.
3 Federal Reserve, FOMC communications related to policy normalization, 9 November 2017. The Fed will increase unwinding of Treasury securities by US$6 billion per month and increase by US$6 billion at 3-month intervals over 12 months until it reaches US$30 billion per month and for MBS by US$4 billion per month and increase in steps of US$4 billion at 3-month intervals until it reaches US$20 billion per month.