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Federal Reserve System

Fed to remove economy's crutch, shrink $4.5T holdings

Federal Reserve Chair Janet Yellen Let a two-day meeting of policymakers that ended Wednesday.

WASHINGTON — The U.S. economy is finally sturdy enough for the Federal Reserve to withdraw the extraordinary support it has provided it since the depths of the recession and financial crisis.

In a move that that could nudge consumer borrowing costs higher, the Fed agreed Wednesday to begin gradually shedding much of the roughly $3.5 trillion in bonds it snapped up during and after the downturn to lower long-term interest rates.

"We're working down our balance sheet because we think in some sense it's no longer needed," Fed Chair Janet Yellen said at a news conference. "We feel the U.S. economy is performing well."

And while the Fed held its key short-term interest rate steady, at a range of 1% to 1¼%, it maintained its forecast for a third rate hike in 2017 and three increases next year. But in a nod to weak inflation, the Fed cut its projection from three rate increases to two in 2019. By 2020, the Fed expects its benchmark rate to be 2.9%, and it trimmed its estimate of the rate over the longer-run to 2.8% from 3%.

Higher interest rates would push up costs for everything from car loans and mortgages to business loans. Fed officials, however, have indicated they could forgo another rate increase late this year if inflation doesn’t accelerate. The Fed lowered its inflation forecast for this year to 1.5% from 1.7% in its June estimate and to 1.9% next year from its prior projection of 2%.

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"If the (inflation) shortfall is persistent, it will be necessary to adjust monetary policy to address that," Yellen said. 

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Storm toll 

“Storm-related disruptions and rebuilding will affect economic activity in the near-term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term,” the Fed said in a statement following the meeting. Despite the impact of the hurricanes, the Fed now expects the economy to grow 2.4% this year, up from its prior forecast of 2%.

The storms are expected to reduce third-quarter economic growth to about 2.2% from 2.7%, economists say, with much of the loss made up in the fourth quarter.

The Fed's future

The Fed’s road map also could be redrawn within months if its leadership is overhauled. Fed Vice Chair Stanley Fischer has announced he’ll step down next month. And Yellen’s term expires in February, though President Trump has said he hasn’t ruled out reappointing the Democrat. Trump also must fill three other vacancies on the Fed’s board of governors.

A milestone

Meanwhile, the widely expected shrinking of the Fed’s bloated balance sheet marks a milestone for the 8-year-old economic recovery. From 2008 to 2014, the Fed purchased more than $3.5 trillion in Treasury bonds and mortgage-backed securities in a campaign to lower long-term interest rates and stimulate a listless economy, swelling its balance sheet to $4.5 trillion.

The unprecedented program was widely credited with staving off a potential depression and has been mimicked by several major central banks around the globe. But with the U.S. economy on solid footing, Fed officials worry the low rates are encouraging investments in higher-yielding assets, increasing the risk of bubbles that eventually may pop.

Rather than sell the bonds outright, which could roil markets, the Fed plans to gradually trim its holdings by not reinvesting the proceeds from some of the assets as they mature. Starting in October, the Fed plans to limit the bonds that roll off its books each month to $10 billion and gradually increase the cap to $50 billion within 12 months.  By early next decade, the Fed’s bond portfolio will likely level off at about $3 trillion, Fed officials have said. That’s below the current $4.5 trillion but still well above the pre-financial crisis level of $900 billion.

Jay Bacow, head of agency mortgage research at Morgan Stanley, says the Fed’s plan, which it has signaled for months, is already priced into 30-year fixed rate mortgages and he expects no further increase in coming months as a result of Wednesday’s announcement. The 30-year mortgage rate is 3.78%, down from about 4% early this year.

Over the next four years, Nomura economist Mark Doms expects the bond program to result in a fairly modest half a percentage point rise in long-term rates for mortgages as well as student and business loans, among other loans with extended terms. That would increase the monthly mortgage payment on a $200,000 home by about $60.

Experts believe other private buyers of Treasury bonds and mortgage-backed securities will fill the void left by the Fed, limiting the impact on borrowing costs. More demand for mortgage bonds -- which are effectively packages of mortgages that have been doled out to home buyers through banks -- increases the price of the bonds and lowers their interest rates.

But Mary Ann Hurley, vice president of fixed income trading at D.A. Davidson & Co., worries there may not be enough buyers to take the Fed’s place when the cap reaches $50 billion monthly. That, she says, could push up mortgage rates by as much as a percentage point over the next several years.

Such an increase “is going to make a bad situation worse,” if the aging economic recovery loses steam, as she believes it will. Fed officials have said they could suspend the balance sheet reduction in the event of economic troubles. But some Fed policymakers have said they believe the program could remain on a kind of autopilot with little expected impact on the financial system or economy.

Yellen told reporters Wednesday that will likely be the case “unless we think the threat to the economy is sufficiently great.”

For the most part, Yellen noted, the Fed still plans to use its benchmark short-term rate as its chief lever to stimulate economic growth or put on the brakes to head off excessive inflation. With the unemployment rate at a low 4.4%, the Fed twice this year has boosted its key interest rate by a quarter percentage point to temper an anticipated pickup in wage and price increases.

Annual wage growth, however, has remained surprisingly contained at 2.5%.  And the Fed’s preferred measure of yearly inflation has fallen to 1.4% after nearing its 2% target early this year.  Yellen has blamed temporary factors, such as a drop in cell phone service rates. But other Fed policymakers have pointed to longer-lasting forces, such as global competition and the shift to discounted online shopping.

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