After its meeting concluded on June 14th, the Fed provided some details about the plan to reduce its holdings of U.S. Treasuries and agency debt and mortgage-backed securities (MBS). Regarding the starting time for the reductions, Fed Chair Yellen said that they could begin “relatively soon if the economy performs in line with the Fed’s forecasts. This comment caused investors to anticipate that the starting time will be in September or October, which was sooner than expected. In a document called the Policy Normalization Principle and Plans, the Fed laid out additional information. They will reduce their holdings by not reinvesting all the principle payments received. Over the last few years, they have held the level of their holdings steady by reinvesting all the principle payments received. The amount of principle payment received that will not be reinvested will start at $10 billion per month and will grow by $10 billion every three months until the monthly total reaches $50 billion. The reduction then will be capped at $50 billion and will continue until the size of the Fed’s holdings has fallen to the desired level. The Fed did not disclose the desired level but did say they expect the [...]
In her semi-annual testimony to Congress, Fed Chair Yellen said that the Fed expects that economic progress will call for "further gradual increases" in the federal funds rate. She also said that it would be "unwise" to wait too long to hike rates. Yellen later added that the Fed will consider in coming months when to begin to reduce the Fed's holdings of MBS. Of note, she said that the Fed will not sell MBS to shrink the holdings, but rather will stop replacing principal reductions. The expected pace of tightening by the Fed increased a little after her testimony, causing MBS to decline.
The FOMC statement and Fed Chair Yellen's press conference has created some volatility, but resulted in just a small net reduction in MBS prices. The statement included some change in language but Yellen pointed out that it did not "signify any change" in the Fed's "intentions" for monetary policy as indicated in prior statements. The phrase "considerable period" remained in the statement, and the term "patient" was added to describe the Fed's attitude in changing monetary policy. The forecasts from Fed officials for the pace of future fed funds rate hikes were lowered a little from their forecasts at the September meeting. Yellen said that the Fed is unlikely to start raising the fed funds rate for "at least the next couple of meetings". The Fed's view is that the economy is improving and that the slack in the labor market is diminishing. According to the Fed, the downward pressure on inflation from lower oil prices is "transitory" and will have little impact on long-run inflation levels. Yellen emphasized that future monetary policy will remain heavily dependent on incoming economic data.
The recently released Fed Minutes and testimony from Fed Chair Yellen have provided more detail in some areas about future Fed policy. There are two primary tools that the Fed is currently using, bond purchases and the fed funds rate. Bond purchases from the Fed, which include both Treasuries and mortgage-backed securities (MBS), exert a direct influence on mortgage rates. The added demand for MBS from the Fed raises MBS prices. Since mortgage rates are set based on MBS prices, this helps keep mortgage rates low. The Fed's portfolio of MBS has been growing at a scheduled pace as the Fed has been reinvesting principal payments received and adding new MBS. The Fed has been tapering its bond purchases, though, and the Minutes indicated that the purchases of new MBS will end in October as expected. After that time, the Fed plans to continue to reinvest principal payments received, which will hold the size of its portfolio steady, at least until the first fed funds rate hike. Principal payments have been averaging $16 billion per month, so investors were pleased that the reinvestment will continue for quite a while. The fed funds rate, a very short-term interest rate, has [...]