Federal Reserve Monetary Policy

September 01, 2017
By Patrick V. Masso, CFA

Over the better part of the last decade, central banks across the world enacted ultra-accommodative policies to combat the lingering effects of the Great Recession.

Let’s travel back in time…In late 2007, the Fed began decreasing from 5.25% the fed funds rate, which is the rate at which financial institutions lend to one another overnight. They continued down this path until the fed funds rate hit a rock bottom range of 0-0.25% in early 2009. Seeing the economy still needed further help, the Fed initiated a series of quantitative easing (QE) programs. Simply speaking, to further reduce the cost of borrowing in the hopes of spurring demand for loans from businesses and consumers, the Fed began purchasing treasury and agency mortgage bonds.

These quantitative easing programs increased the size of the Fed’s balance sheet from approximately $875 billion to $4.5 TRILLION – yes, with a “T” (see chart on next page). That’s a lot of bond buying! In fact, the Fed now owns nearly 30% of all agency mortgage-backed bonds. In late 2015, a reversal of these ultra-accommodative measures began unfolding. As shown in the chart above, the fed funds rate was increased and now stands at 1-1.25%. A healthier economy should be able to absorb higher interest rates.

Now, what to do about that $4.5 trillion bond portfolio…During a press conference on September 20th, Fed Chair Janet Yellen announced a plan to begin reducing the size of this portfolio. Selling treasury and mortgage bonds will need to be undertaken with a steady hand so as not to disrupt global bond markets. The plan is to start selling about $10 billion per month, with the amount gradually increasing over time.

Goldman Sachs estimates a shrinking of the bond portfolio will cause the 10-Year Treasury to increase by about 0.10% per year over the next several years due to the increased supply from these bond sales. Over the long run, this is a net positive for bond investors, because they will earn higher interest rates on their investments. In the shorter term, higher interest rates could weigh on prices of bonds currently owned and result in relative underperformance of high dividend-yielding stocks in the telecommunications, utilities, consumer staples, and real estate sectors.

It will become a little more expensive to finance a small business loan or borrow money to purchase a house or car, too.

Overall, these monetary policy gyrations should be viewed as the Fed’s stamp of approval that the economy is strong enough to bear the burden of higher borrowing costs. None of this is set in stone. Expect the monetary policymakers to adjust the trajectory of the fed funds rate and bond purchases along the way as more information is received on the health of the global economy.

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