US Federal Reserve Building

Broking and financial firm HDFC Securities Ltd said it does not expect the US Federal Reserve to start sucking out the liquidity that it has infused into the global financial market in the last nine years any time soon.

The comments came in the wake of the release of the minutes of the Federal Open Market Committee meeting that indicated that the Fed would begin selling some of the bonds its purchased under ‘quantitative easing’ policy later this year. Read the relevant section of the minutes at the bottom of this article.

ARMAGEDDON?

The US Federal Reserve has pumped in around $4 trillion into the US financial ecosystem, starting in late 2008 and ending in late 2014.

From around 600 bln worth of treasury bills as of 2007, its holdings have zoomed to about 2.45 tln of treasury holdings, 1.77 trl of mortgage-backed securities and various other debt instruments such as banks notes totaling 4.5 tln todate.

As it bought these instruments, it released a lot of money into the global financial system. This money was instrumental in lifting the prices of various assets — such as stocks, real estate and even paintings, to unprecedented levels over the last nine years.

Now, when it takes the money back, the prices of all these assets will climb back down.

NOT HAPPENING SOON

However, HDFC Securities said the central bank is unlikely to go in for such a drastic option, especially since it has not made much headway on its previously announced interest hike plans.

“We believe that the Fed’s talk of a balance sheet contraction, even before all the planned hikes have gone through this year, is to bring the markets down to terrafirma, rather than any genuine desire to do so at this juncture,” said VK Sharma, Head of Private Client Group at HDFC Securities.

Sharma said if the Federal Reserve should probably not be talking about selling its bonds and reversing its quantitative easing at this time.

“We believe that the Fed has acted too prematurely,” Sharma said. “We say this because one, the Trump regime has not been able to come out with a viable health proposal. Two: Trump has still not thrown any further light on his promised tax breaks, and three, with so much of an uncertainty, where was the need to further muddle the waters by throwing in this spanner of balance sheet contraction?”

Sharma said the markets do not seem to believe that the Fed will indeed start selling its securities, going by bond prices. Prices of bonds should have fallen, and their yields increased, if the market really expected the central bank to carry through with its promise.

“But we see.. (that) the yield on the 10 year has fallen. The ten year bond closed with a yield of 2.334%, down 0.030 from 2.364%…So the conclusion that we draw is that though the Fed may have plans to contract its balance sheet, it may not do so in the near future.”

Relevant extracts of FOMC Minutes

In their discussion, policymakers reaffirmed the approach to balance sheet normalization articulated in the Committee’s Policy Normalization Principles and Plans announced in September 2014. In particular, participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings. Most participants expressed the view that changes in the target range for the federal funds rate should be the primary means for adjusting the stance of monetary policy when the federal funds rate was above its effective lower bound. A number of participants indicated that the Committee should resume asset purchases only if substantially adverse economic circumstances warranted greater monetary policy accommodation than could be provided by lowering the federal funds rate to the effective lower bound…

Consistent with the Policy Normalization Principles and Plans, nearly all participants preferred that the timing of a change in reinvestment policy depend on an assessment of economic and financial conditions. Several participants indicated that the timing should be based on a quantitative threshold or trigger tied to the target range for the federal funds rate. Some other participants expressed the view that the timing should depend on a qualitative judgment about economic and financial conditions. Such a judgment would importantly encompass an assessment by the Committee of the risks to the outlook, including the degree of confidence that evolving circumstances would not soon require a reversal in the direction of policy. Taking these considerations into account, policymakers discussed the likely level of the federal funds rate when a change in the Committee’s reinvestment policy would be appropriate. Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year. Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner. Some participants expressed the view that it might be appropriate for the Committee to restart reinvestments if the economy encountered significant adverse shocks that required a reduction in the target range for the federal funds rate.

When the time comes to implement a change to reinvestment policy, participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS (mortgage-backed securities)… An approach that phased out reinvestments was seen as reducing the risks of triggering financial market volatility or of potentially sending misleading signals about the Committee’s policy intentions while only modestly slowing reductions in the Committee’s securities holdings. An approach that ended reinvestments all at once, however, was generally viewed as easier to communicate while allowing for somewhat swifter normalization of the size of the balance sheet. To promote rapid normalization of the size and composition of the balance sheet, one participant preferred to set a minimum pace for reductions in MBS holdings and, if and when necessary, to sell MBS to maintain such a pace.

Nearly all participants agreed that the Committee’s intentions regarding reinvestment policy should be communicated to the public well in advance of an actual change. It was noted that the Committee would continue its deliberations on reinvestment policy during upcoming meetings and would release additional information as it becomes available.

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