The Federal Reserve announced Wednesday that it will begin unwinding its massive balance sheet beginning in October, a move that could push up longer-term mortgage rates.
Also, as widely expected, the central bank’s Federal Open Market Committee (FOMC) left the target federal funds rate unchanged at the conclusion of its two-day meeting this week, setting the stage for a possible rate hike in December.
The Fed signaled in June that it would begin to reduce a portion of its $4.5 trillion in holdings in U.S. Treasurys and mortgage-backed securities (MBS) that were largely accumulated during a bond-buying stimulus program after the Great Recession.
The balance sheet is now roughly five times the size of its pre-recession level. Some analysts believe the Fed will try to reduce that over time to the range of $2 trillion to $2.5 trillion.
Fed Chair Janet Yellen told reporters Wednesday that the easing efforts did its job, with studies suggesting that it may have lowered mortgage rates by a full percentage point. She emphasized that the unwinding will be slow and gradual; however, she also indicated that it would take a severe downturn for the Fed to stop tapering.
“By limiting the volume of securities that private investors will have to absorb as we reduce our holdings, the caps should guard against outsized moves in interest rates and other potential market strains,” Yellen said during the news conference on Wednesday following the FOMC meeting.
The tapering could put upward pressure on longer-term rates, however. The Fed ended the stimulus program in October 2014 by ceasing to add to its holdings, but has continued to reinvest in securities to maintain its balance sheet at the current level. As the demand for the agency MBS and Treasurys decreases with the Fed pullback, it may put pressure on rates. Higher interest rates may be required to entice more private investors into the MBS market.
According to a schedule it first announced in June, the Fed will allow $6 billion in U.S. Treasury holdings and $4 billion in mortgage-backed securities and agency debt to roll off its balance sheet each month. This level will continue each month through December. The caps will then step up gradually to $30 billion monthly in Treasury holdings and $20 billion in agency debt next year.
The Fed’s move to reduce its balance sheet is a sea-changing event for the mortgage industry, according to analysts.
“For much of the past decade, the Fed has been the largest investor in mortgages in the world,” said Mike Fratantoni, chief economist for the Mortgage Bankers Association. “We expect that private investors will, over time, step in to buy MBS,” he added. “But we can’t be certain how quickly they will replace the steady demand that the Fed has been providing.”
Fratantoni also said the move was “very well telegraphed” and probably won’t have much impact immediately on rates. Over time, however, as the Fed picks up the pace, it could cause some rate volatility.
In its other major decision, Fed policymakers left the benchmark rate unchanged in the range of 1 to 1.25 percent. Fratantoni said the Fed’s statement was “relatively hawkish,” suggesting a rate hike in December, and possibly three or four increases each year until the fund target range hits 3 percent.
“Even though inflation remains relatively low, the tight job market is leading the Fed to slowly move rates up to prevent the economy from overheating,” Fratantoni said.
Most analysts have predicted the FOMC will raise the rate by a quarter percent at least one more time this year. The most likely date is following the Dec. 12-13 FOMC meeting, for which Yellen has scheduled a news conference. The FOMC also has a two-day meeting slated for Oct. 31 and Nov. 1.