WASHINGTON – The Federal Reserve will begin shrinking the enormous portfolio of bonds it amassed after the 2008 financial crisis to try to sustain a frail economy. The move reflects a strengthened economy and could mean higher rates on mortgages and other loans over time.
The Fed announced Wednesday that it will let a small portion of its $4.5 trillion balance sheet mature without being replaced, starting in October with reductions of $10 billion a month and gradually rising over the next year to $50 billion a month.
The central bank left its key short-term rate unchanged but hinted at one more hike this year – most likely in December – if persistently low inflation rebounds. The Fed policymakers’ updated economic forecasts show an expectation for three more rate hikes in 2018.
The Fed’s policymaking committee approved its action on a 9-0 vote after ending its latest meeting.
Stocks turned lower after the announcement. Bond yields rose, leading to gains for banks but losses for high-dividend stocks like household goods makers and utilities. Income-seeking investors find those stocks less appealing when bond yields move up.
John Silvia, chief economist at Wells Fargo, said some investors appeared surprised that the Fed still expects to raise rates by December. With Hurricanes Harvey and Irma clouding some economic data – temporarily raising gas prices, likely restraining hiring and potentially depressing growth in the July-September quarter – some analysts assumed the Fed wouldn’t have enough information by December to assess whether the economy had rebounded from the storms.
“A lot of people were thinking that (the Fed) would pass in December,” Silvia said.
At a news conference, Chair Janet Yellen said the Fed still believes that persistently low inflation – below the Fed’s 2 percent target rate for four years – is temporary. Yellen said several factors have held inflation down: A job market still healing from the Great Recession, lower energy prices and a strong dollar, which has reduced the costs of imports.
She said the Fed would adjust its policymaking if it thought the causes of low inflation had become permanent.
In its policy statement, the Fed took note of Harvey, Irma and Hurricane Maria, which it said had devastated many communities. But it said history suggests that the storms were unlikely to affect the national economy over the long run.
Under the plan the Fed announced, it will start to allow a slight $10 billion in holdings to roll off the balance sheet each month – $6 billion in Treasurys and $4 billion in mortgage bonds. That figure would inch up by $10 billion each quarter until it reaches $50 billion in monthly reductions in October 2018. After that, the monthly reductions will remain steady.
The Fed has telegraphed its move for months, and investors are thought to be prepared for it. Still, no one is sure how the financial markets will respond over the long run. The risk exists that investors could become spooked by the rising number of bonds being transferred back into private hands. If that were to happen, long-term rates might surge undesirably high, which could weigh on the economy.
To avoid spooking investors, the Fed’s plan for shrinking its balance sheet is so gradual that the total would remain above $3 trillion until late 2019. Some economists say they think the figure could end up around $2.5 trillion, still far above the $900 billion the Fed held in its portfolio in pre-crisis days.
The question of when and how the Fed will manipulate its main policy lever – its target for short-term rates – in coming months is less clear. After leaving its benchmark rate at a record low for seven years after the 2008 crisis, the Fed has modestly raised the rate four times since December 2015 to a still-low range of 1 percent to 1.25 percent.
The Fed did lower its projection for its so-called neutral rate. That’s the point at which its benchmark rate is considered to be neither stimulating economic growth nor restraining it. That neutral rate dropped to 2.9 percent in the new forecast, down from 3 percent in the Fed’s June forecast.
The Fed has felt confident to raise rates because it appears to have met one of its key mandates: Maximizing employment. The unemployment rate is just 4.4 percent, near a 16-year low. The Fed, though, has yet to achieve its other objective of stabilizing prices at a 2 percent annual rate. Inflation has remained persistently below that level. As a result, financial markets have seemed unsure about whether the Fed would raise rates again before year’s end.
In addition to forecasting future rate hikes, analysts are trying to divine whether President Donald Trump will re-nominate Yellen to a second four-year term. The only other potential choice for Fed chair Trump has mentioned is Gary Cohn, a former Goldman Sachs executive who leads the president’s National Economic Council. But Cohn appears to have fallen out of favor.
At her news conference, Yellen declined to say whether she would like to serve a second term. She met several months ago with Trump, who spoke favorably of her afterward, but Yellen said she hasn’t spoken with Trump since.
With several seats on the Fed’s board open or soon to be open, Trump has made just one nomination, that of Randal Quarles to be vice chairman for supervision. One vacancy about to open is the seat of Vice Chairman Stanley Fischer, who is stepping down next month.