January 29, 2020 / 11:23 PM / 21 days ago

What's next for the Federal Reserve's balance sheet?

(Reuters) - The Federal Reserve will keep injecting cash into the banking system and buying billions of dollars of Treasury bills for a few more months, but it aims to start dialing back on both in the second quarter, Chair Jerome Powell said Wednesday.

FILE PHOTO: The Federal Reserve building is pictured in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie//File Photo

Powell’s comments, following the Fed’s latest interest-rate setting meeting, provided investors with some clarity on just how much longer the Fed plans to keep pumping liquidity into U.S. money markets and lifting the level of bank reserves. It has been doing both since last fall in response to a jarring surge in borrowing costs in bank funding markets.

Here is a look at what is known about the central bank’s plans for its bond holdings and market interventions:

WHEN DID THE FED START REBUILDING ITS BALANCE SHEET AND WHY?

The Fed acquired a vast portfolio of Treasuries and mortgage-backed securities in the wake of the financial crisis through three operations known as quantitative easing, or QE. These were meant to stimulate the economy by bringing down long-term yields and lowering borrowing costs.

It started reducing the size of its balance sheet in late 2017 to slowly unwind that stimulus, a process that ended last August. But September’s money market upheaval indicated officials had let the balance sheet get too small.

In response, it began daily cash injections in the repurchase agreement, or repo, market. In addition, it started buying Treasury bills to return bank reserves to level from early September.

HOW MUCH IS THE FED BUYING AND HOW LONG WILL IT CONTINUE?

Since mid-October, the Fed has been buying $60 billion a month of T-bills, and reserve levels have risen by more than $270 billion since then to roughly $1.67 trillion.

Powell said Wednesday officials expect to reach an “ample” level of reserves, where the market is less reliant on the Fed, at some point in the second quarter.

While Powell did not give a specific target, he set a floor: $1.5 trillion. That was roughly the level in early September before the liquidity problems arose. “We want to be clear that will be the bottom end of the range,” Powell said.

Powell said the aim is to reduce support in the least disruptive and most transparent manner possible, but he offered no specific schedule.

Jon Hill, an interest rate strategist for BMO Capital Markets, expects the Fed could taper purchases to $30 billion a month starting in March. Others expect the Fed to hold the current pace for longer.

POWELL SAYS THIS IS NOT QUANTITATIVE EASING. HOW DOES IT DIFFER?

The Fed’s previous rounds of asset purchases focused on long-term bonds in an effort to bring down interest rates. The purchases were paired with a strong message from the Fed that it was trying to stimulate the economy and intended to keep rates low.

This time, it is buying only short-term Treasury bills and making no pledge about long-term rate levels. Minneapolis Fed President Neel Kashkari recently likened it to trading one short-term risk-free investment for another.

IS THE FED’S BALANCE SHEET PROGRAM LIFTING THE STOCK MARKET?

A number of investors say so, contending it is inadvertently fueling higher stock prices because some market participants still associate it with stimulus.

Powell deflected questions about that on Wednesday, repeating his assertion the current action is purely technical and is not meant to be stimulative.

“It’s very hard to say what is affecting financial markets with any precision,” Powell said during the press conference.

Still, some investors argue the program has played an outsized role in the bull market’s latest leg higher - either directly or by reinforcing the perception that the central bank is averse to market turbulence and stands ready to step in if things get too rocky. 

That is stoking worries by some over how markets will react if the central bank winds down the program too abruptly.

“If the change in balance sheet comes as a shock, the equity markets would probably take that as bad news,” said Joseph Sroka, chief investment officer at NovaPoint in Atlanta. “But it seems like (the Fed’s) priority is to be as transparent as possible, which should be less disruptive.”

Reporting by Jonnelle Marte; Additional reporting by Stephen R. Culp; Editing by Dan Burns

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