Large-scale asset purchase programs
“Given elevated unemployment and persistently low inflation, monetary policy remains very accommodative,” said Pianalto.
The Federal Reserve’s approach to the implementation of monetary policy has evolved considerably since 2007, and particularly since late 2008, when the FOMC established a near-zero target range for the federal funds rate. Since late 2008, the Federal Reserve has greatly expanded its holding of longer-term securities through an unconventional means commonly known as “quantitative easing.”
For long, the quantitative easing has put the downward pressure on the long-term interest rates, as the Fed continued to provide the excess liquidity to spur economic activity and job creation by making financial conditions more accommodative.
Let’s take a look at some examples:
Pianalto said on tapering, “Even though we are scaling back our asset purchases, we are still buying a sizable amount. At this point, we have accumulated about $4 trillion worth of securities—which is four times the size of the Federal Reserve’s balance sheet six years ago before the financial crisis and recession.” In December 2013, the Federal Reserve announced that it would modestly slow the pace of additional MBS and longer-term Treasury securities purchases if incoming information broadly shows ongoing improvement in labor market conditions and inflation moving back toward the FOMC’s 2% longer-run objective. So, on March 18-19, the Fed maintained its stance on asset purchase and reduced the bond buying by $10 billion, which means that the Fed would buy $25 billion of agency mortgage-backed securities (MBS) and $30 billion worth long-term Treasury securities in April 2014, compared to the $65 billion ($30 billion MBS and $35 billion long term Treasury) announced in January 2014.
Unwinding the balance sheet
At present, the U.S. coffers a reserve balance of $4.1 trillion, and the FOMC committee is still maintaining its existing policy of reinvesting principal payments from its holdings in agency mortgage-backed securities and on rolling over maturing Treasury securities at auction. This means that the FOMC is still piling on a substantial amount of longer-term securities in its reserves.
Other things being constant, when the Fed purchases long-term treasury securities from dealers, the proceeds are deposited in the dealers’ banks. This increases the liquidity in the markets. As the money supply becomes cheaper, the cost of funds decreases stimulating consumer and business spending. Higher spending has a rippling effect on the economy. Overall stock market reflected by SPDR S&P 500 ETF (SPY), and the iShares Core S&P 500 ETF (IVV), which track large-cap equities of companies like Apple (AAPL) and Exxon Mobil (XOM), tend to profit from higher spending. However, persistent low interest rate can severely damage the margins of the corporate, as the cost of business weighs down the profits, which may eventually boil down to higher unemployment.
Lower interest rates boost the bond market (BND). As the bond prices share an inverse relationship with interest rates, reduction in interest rates leads to an increase in bond prices and vice versa.
Pianalto said, “A decision to stop reinvesting the maturing Treasuries and mortgage-based debt will be the Fed’s first step in unwinding its balance sheet, which has grown to exceed $4 trillion in the wake of the recession and financial crisis.”
The next part of the series discusses what will be the Fed’s next move in the upcoming FOMC meeting scheduled for April 29-30, 2014.