Federal Reserve officials are considering a proposal to schedule limited sales of bonds from the central bank's $2.2 trillion balance sheet as part of a range of tools for withdrawing record monetary stimulus.
The Federal Open Market Committee discussed asset sales at its November meeting, with some members in favor and others warning that it would cause "sharp increases" in longer-term interest rates, according to minutes of the meeting released Nov. 24. A middle route, now being studied, would allow small amounts of bonds to be unloaded at announced times.
"The attitude toward asset sales is changing in terms of more in favor and more open-minded, and doing it very gradually," said former Fed governor Laurence Meyer, who is now vice chairman of Macroeconomic Advisers LLC. Devising a plan for pulling back stimulus "is under way intensively on the Federal Open Market Committee," he said.
Fed Chairman Ben Bernanke is trying to wind down emergency stimulus programs, while alleviating concerns that inflation will accelerate as the economy picks up. U.S. government bonds just finished the worst year since the 1970s after the Obama administration borrowed record sums to help drive the rebound from recession. Yields on 10-year notes are near their highest level in four months, rising to 3.847% as of Thursday afternoon.
Without first reducing or locking up the $1 trillion Bernanke pumped into financial markets, policymakers may raise their target for the benchmark interest rate only to watch it trade below that level. The Fed cut the federal funds rate, to between zero and 0.25% in December of 2008 and kept it there at the most recent FOMC gathering, last month.
"Here is the worry: What if they try to tighten and they lose control of the federal funds rate?" said Mark Spindel, the chief investment officer of Potomac River Capital LLC in Washington, which specializes in inflation-linked bonds. "The challenge they have is to articulate how they are going to tighten and make sure all these tools work together."
The Fed has expanded reserves through emergency programs purchasing $1.7 trillion in bonds. At Dec. 23, the central bank held $776.5 billion of U.S. Treasury securities, $160 billion of bonds issued by federal agencies and $910 billion of mortgage bonds guaranteed by companies such as Fannie Mae and Freddie Mac.
The Fed is developing tools that can help take reserves off the market. Last week it proposed selling term deposits to banks, which would remove reserves from the day-to-day trading market, locking them up for up to six months.
The Federal Reserve Bank of New York began last month testing reverse repurchase agreements, another way to draw cash from banks.
The federal funds market underscores how the Fed may need to use several tools to hit its interest-rate target. While the Fed promises to pay banks 0.25% to keep excess funds on deposit at the central bank, the so-called effective rate, or market rate, averaged 0.12 basis point in December.
Fannie Mae and other government-sponsored enterprises that are ineligible to deposit money at the Fed "have pulled down" the fed funds rate by selling funds in the market, New York Fed researchers said in a paper last month.
Fed officials must be wary about managing reserves and raising interest rates, economists said. Even small bond sales could nudge up the cost of home loans.
Freddie Mac said the average 30-year fixed rate rose to 5.14% for the week that ended Dec. 31, the highest since August. A rise in short-term rates would boost the cost on floating-rate loans.
"If they get this wrong, volatility is going to be through the roof," said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. LLC. "Investors are overdiscounting the difficulty that is coming our way when the Fed begins the process of raising interest rates."
The Fed will increase the benchmark rate in the third quarter, according to the median forecast of economists surveyed by Bloomberg News in December. Fed Vice Chairman Donald Kohn is among officials who have said the recovery needs to be self-sustaining, before the Fed tightens.
Fed officials are considering the sequence for using their various tools for withdrawing monetary stimulus. They may start by raising the interest on the reserves rate and draining reserves, followed by asset sales, Meyer said in a Dec. 15 research note.
A second possible sequence would be first draining off excess reserves, then raising the interest on the reserves rate later, followed by asset sales, he said.
"They are going to have to sell assets" to maintain control over the benchmark lending rate, said Brian Yelvington, director of fixed-income strategy at the bond broker Knight Libertas LLC. "The volatility of the effective federal funds rate around the target is probably going to be a lot greater than it has been."