Fed Mulls Putting a 'Not For Sale' Sign on Its Assets


The U.S. Federal Reserve isconsidering jettisoning a plan to eventually sell off themassive haul of bonds it is now buying, a politically defensivestrategy that would have the added benefit of supporting theeconomy for years to come.

In what would be a revision of their blueprint for theeventual tightening of monetary policy, Fed officials have saidthey could simply allow the trillions of dollars in securitiesthey have bought through three rounds of quantitative easing tomature.

Fed Chairman Ben Bernanke and other officials have said adecision not to sell the mortgage and Treasury bonds would onlyadd about a year to the process of returning the central bank'sbalance sheet to a more normal size of around $1 trillion,probably around 2020. It is worth some $3 trillion now, andcould swell to near $4 trillion by year end.

While a new "exit strategy" is not likely to emerge from theFed's next meeting on March 19-20, officials plan to review theblueprint soon because it has not been updated since mid-2011.

Under the existing plan, the Fed would commence asset salesat some point after policymakers begin to raise interest rates.

But things have changed since the plan was put in place.

Not only has the central bank's balance sheet grown invalue, but the average duration on the bonds has risen by 3years to about 10 years. That means the Fed could suffer biglosses on its portfolio later this decade if it sells assetswhen interest rates climb.

The central bank regularly sends the bulk of its earnings tothe U.S. Treasury. While it has never missed a payment, some Fedpolicymakers fear portfolio losses in the years ahead wouldexpose it to attacks from critics in Congress and could promptlawmakers to clamp down on their freedom to pursue monetarypolicy as they see fit.

If they do not sell the bonds, they will not realize a loss.

A bigger concern than politics, however, may be the U.S.economy's slow recovery from recession and its only tepidresponse to the most accommodative monetary policies ever.

Hanging on to the bonds would keep downward pressure onlonger-term borrowing costs, encouraging economic growth evenafter the Fed starts to raise overnight rates from near zero,where they have been since 2008. The strategy would also avoiddisrupting financial markets with possibly huge sales.

"That's a double barrel hit and that would be way too much,"said John Silvia, the chief economist at Wells Fargo SecuritiesLLC. "The market can deal with assets rolling off," he said,referring to bonds maturing and not being replaced with newpurchases, but it "would have a tough time" judging the Fed'ssales.

Of course, the Fed is already disrupting the market with itsoutsized balance sheet. Not selling the assets would mean atleast another year in that uncomfortable position, when theeconomy may not need that support.

Political Benefits?

As part of its efforts to spur the economy after the deepestrecession since the Great Depression, the central bank iscurrently buying $85 billion in bonds per month. It has said itintends to do so until the troubled labor market improves.

Through the strategy announced in June 2011, when the timeis right the Fed plans to stop reinvesting principal on thesecurities and then start to drain the massive amounts of cashit has injected into the banking system.

Later, it would raise the benchmark federal funds rate, andfinally start selling the remaining bonds over a five-year spanto shrink the balance sheet down to size.

But in congressional testimony last week, Bernanke said theFed will have to review that strategy some time soon and notedthat it could simply hold the securities to maturity, which hesaid would add perhaps an extra year to the whole process.

Holding the securities could even be an alternative to assetpurchases that would give the economy a bit of a lift, he said.

In a recent speech, Fed Governor Jerome Powell argued thatsimply allowing assets to run off the balance sheet wouldaddress growing concerns that selling older-issuemortgage-backed securities could destabilize markets.

Powell added that "it would also smooth remittances,"referring to the Fed's payments to the Treasury.

Central bank researchers warned in January that the Fedcould miss payments to the Treasury for up to four years, andthat the loss could spike as high as $125 billion in 2019, undera scenario in which securities are sold and rates were higherthan expected.

Making things worse, at least politically, the losses couldcome at a time when the Fed is paying banks higher interest onexcess reserves. That could attract unwelcome scrutiny from U.S.lawmakers, some of whom have sharply criticized the bond buying.

"The Fed's official view is they will not let politicsinfluence their view. My view is, that may be a little bitnaive," said James Hamilton, economics professor at Universityof California at San Diego and a research associate of theNational Bureau of Economic Research.

"One way to avoid that political side of things would bejust to never realize those losses."

A recent paper co-authored by Hamilton suggests it wouldtake about two years longer - until 2020 or so - to normalizethe balance sheet if the Fed were to hang on to the securities.

Economic Benefits?

A decision not to sell bonds, especially if statedforcefully by the Fed, would be stimulative both now and in thefuture because longer-term expectations about how many bondswill be in the market can effect the current pricing.

Theoretically, it could also allow the Fed to curb itscurrent bond buying earlier than planned, or raise rates sooner.

Still, there will likely be resistance to the idea from themore hawkish wing of the Fed's policymakers who are notcomfortable with such a large balance sheet.

Charles Plosser, head of the Philadelphia Federal Reserve,said winding down the balance sheet should depend on marketconditions at the time, and on how effectively the central bankcan control the flow of private bank reserves back into theeconomy.

"We don't know the answer to that, so I think it's hard topre-commit to saying we won't sell assets, even in the face ofrising inflation rates," Plosser told reporters on Wednesday. "Iwould be nervous about that effort."

Once the Fed starts to lift short-term rates, it might thenbe wise to sell some assets if economic growth is strong andbond markets seem able to absorb even higher longer-term rates.

The Fed might be smarter to hang on to the assets, however,if economic growth starts to slow and longer-term rates arealready rising significantly.

Michael Feroli, chief U.S. economist at JPMorgan, said thebenefits of a "no asset sale" policy are compelling enough thatthere is a good chance the Fed will adopt it.

"I'm not sure when we will see a new exit strategy," headded, "but I wouldn't be surprised to see one by June."