FOMC Excerpt: Longer Run Portfolio Design Considerations >

WASHINGTON (MNI) - The following is an excerpt from the Federal Open 

Market Committee minutes of the April 30 - May 1 meeting, published 

Wednesday:

     Participants resumed their discussion of issues related to balance 

sheet normalization with a focus on the longrun maturity composition of 

the System Open Market Account (SOMA) portfolio. The staff presented two 

illustrative scenarios as a way of highlighting a range of implications 

of different long-run target portfolio compositions. In the first 

scenario, the maturity composition of the U.S. Treasury securities in 

the target portfolio was similar to that of the universe of currently 

outstanding U.S. Treasury securities (a proportional portfolio). In 

the second, the target portfolio contained only shorterterm securities 

with maturities of three years or less (a shorter maturity portfolio). 

The staff provided estimates of the capacity that the Committee would 

have under each scenario to provide economic stimulus through a maturity 

extension program (MEP). The staff also provided estimates of the extent 

to which term premiums embedded in longer-term Treasury yields might be 

affected under the two different scenarios. Based on the staffs 

standard modeling framework, all else equal, a move to the illustrative 

shorter maturity portfolio would put significant upward pressure on term 

premiums and imply that the path of the federal funds rate would need to 

be correspondingly lower to achieve the same macroeconomic outcomes as 

in the baseline outlook. However, the staff noted the uncertainties 

inherent in the analysis, including the difficulties in estimating the 

effects of changes in SOMA holdings on longer-term interest rates and 

the economy more generally. 

     The staff presentation also considered illustrative gradual and 

accelerated transition paths to each long-run target portfolio. Under 

the illustrative gradual transition, reinvestments of maturing 

Treasury holdings, principal payments on agency mortgage-backed 

securities (MBS), and purchases to accommodate growth in Federal Reserve 

liabilities would be directed to Treasury securities with maturities in 

the long-run target portfolio. Under the illustrative accelerated 

transition, the reinvestment of principal payments on agency MBS and 

purchases to accommodate growth in Federal Reserve liabilities would be 

directed to Treasury bills until the weighted average maturity (WAM) of 

the SOMA portfolio reached the WAM associated with the target portfolio. 

Depending on the combination of long-run target composition and the 

transition plan for arriving at that composition, the staff reported 

that, in the illustrative scenarios, it could take from 5 years to more 

than 15 years for the WAM of the SOMA portfolio to reach its longrun 

level. 

     In its Statement Regarding Monetary Policy Implementation and 

Balance Sheet Normalization, the Committee noted that it is prepared to 

adjust the size and composition of the balance sheet to achieve its 

macroeconomic objectives in a scenario in which the federal funds rate 

is constrained by the effective lower bound. Against this backdrop, 

participants discussed the benefits and costs of alternative long-run 

target portfolio compositions in supporting the use of balance sheet 

policies in such scenarios. 

     In their discussion of a shorter maturity portfolio, many 

participants noted the advantage of increased capacity for the Federal 

Reserve to conduct an MEP, which could be helpful in providing policy 

accommodation in a future economic downturn given the secular decline in 

neutral real interest rates and the associated reduced scope for 

lowering the federal funds rate in response to negative economic shocks. 

Several participants viewed an MEP as a useful initial option to address 

a future downturn in which the Committee judged that it needed to employ 

balance sheet actions to provide appropriate policy accommodation. 

Participants acknowledged the staff analysis suggesting that creating 

space to conduct an MEP by moving to a shorter maturity portfolio 

composition could boost term premiums and result in a lower path for the 

federal funds rate, reducing the capacity to ease financial conditions 

with adjustments in shortterm rates. A number of participants noted, 

however, that the estimates of the effect of a move to a shortermaturity 

portfolio composition on the long-run neutral federal funds rate are 

subject to substantial uncertainty and are based on a number of strong 

modeling assumptions. For example, estimates of term premium effects 

based on experience during the crisis could overstate the effects that 

would be associated with a gradual evolution of the composition of the 

SOMA portfolio. In addition, a shift in the composition of the SOMA 

portfolio could result in changes in the supply of securities that would 

tend to offset upward pressure on term premiums. Nonetheless, other 

participants expressed concern about the potential that a shorter 

maturity portfolio composition could result in a lower long-run neutral 

federal funds rate. Moreover, while a shorter maturity portfolio would 

provide substantial capacity to conduct an MEP, some participants raised 

questions about the effectiveness of MEPs as a policy tool relative to 

that of the federal funds rate or other unconventional policy tools. 

These participants noted that, in a situation in which it would be 

appropriate to employ unconventional policy tools, they likely would 

prefer to employ forward guidance or large-scale purchases of assets 

ahead of an MEP. In the view of these participants, the potential 

benefit of transitioning to a shorter maturity SOMA composition in terms 

of increased ability to conduct an MEP might not be worth the potential 

costs. 

     In their discussion of a proportional portfolio composition, 

participants observed that moving to this target SOMA composition would 

not be expected to have much effect on current staff estimates of term 

premiums and thus would likely not reduce the scope for lowering the 

target range for the federal funds rate target in response to adverse 

economic shocks. As a result, several participants judged the 

proportional target composition to be well aligned with the Committees 

previous statements that changes in the target range for the federal 

funds rate are the primary means by which the Committee adjusts the 

stance of monetary policy. In addition, several participants noted that 

while the staff analysis suggested a proportional portfolio would not 

contain as much capacity to conduct an MEP as a shorter maturity 

portfolio, it still would contain meaningful capacity along these lines. 

Some participants noted that a proportional portfolio would also help 

maintain the traditional separation between the Federal Reserves 

decisions regarding the composition of the SOMA portfolio and the 

maturity composition of Treasury debt held by the private sector. 

However, a number of participants judged that it would be desirable to 

structure the SOMA portfolio in a way that would provide more capacity 

to conduct an MEP than in the proportional portfolio. In addition, a 

couple of participants noted that a shorter maturity portfolio would 

maintain a narrow gap between the average maturity of the assets in the 

SOMA portfolio and the short average maturity of the Federal Reserves 

primary liabilities. 

     Participants also discussed the financial stability implications 

that could be associated with alternative long-run target portfolio 

compositions. A couple of participants noted that a proportional 

portfolio could imply a relatively flat yield curve, which could result 

in greater incentives for reach for yield behavior in the financial 

system. That said, a few participants noted that a shorter maturity 

portfolio could affect financial stability risks by increasing the 

incentives for the private sector to issue short-term debt. A couple of 

participants judged that financial market functioning might be adversely 

affected if the holdings in the shorter maturity portfolio accounted for 

too large a share of total shorter maturity Treasury securities 

outstanding. 

     In discussing the transition to the desired long-run SOMA portfolio 

composition, several participants noted that a gradual pace of 

transition could help avoid unwanted effects on financial conditions. 

However, participants observed that the gradual transition paths 

described in the staff presentation would take many years to complete. 

Against this backdrop, a few participants discussed the possibility of 

following some type of accelerated transition, perhaps including sales 

of the SOMAs residual holdings of agency MBS. In addition, several 

participants suggested that the Committee could communicate its plans 

about the SOMA portfolio composition in terms of a desired change over 

an intermediate horizon rather than a specific long-run target. 

     Several participants expressed the view that a decision regarding 

the long-run composition of the portfolio would not need to be made for 

some time, and a couple of participants highlighted the importance of 

making such a decision in the context of the ongoing review of the 

Federal Reserves monetary policy strategies, tools, and communications 

practices. Some participants noted the importance of developing an 

effective communication plan to describe the Committees decisions 

regarding the long-run target composition for the SOMA portfolio and the 

transition to that target composition. 

     ** MNI Washington Bureau: (202)371-2121 ** 

[TOPICS: MMUFE$,M$U$$$,MT$$$$]