Against that backdrop, an important policy decision regarding the Federal Reserve’s portfolio was made at the August FOMC meeting, when the Committee decided to halt this run-off and instead hold the size of the SOMA portfolio steady. To achieve this, the FOMC directed the Desk to purchase longer-term Treasury securities as needed to offset any principal payments realized on our holdings of agency debt and agency MBS. 1 That was not just a symbolic policy decision, but instead involved a meaningful shift in the path of the balance sheet. At the time of the meeting, the Desk was projecting that about $ billion of the Federal Reserve’s MBS holdings would be paid down from that time to the end of 2011. In addition, another $ billion of agency debt holdings would mature over that period. Thus, the total portfolio was expected to shrink by nearly $ billion by the end of 2011. The reinvestment decision therefore amounted to a sizable program to purchase longer-term Treasury securities. The effect of asset purchases on the economy remains a point of ongoing debate, with some uncertainty about the channels through which such purchases operate and the magnitude of those effects. My own perspective is aligned with the view expressed by Chairman Bernanke in Jackson Hole – that the effects arise primarily through a portfolio balance channel. 2 Under that view, our asset holdings keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear.
As rates declined in response to a weakening of the economy, the Federal Reserve’s MBS holdings would decline more rapidly, effectively adding to the supply of duration held by the market. 4 This increase in the duration held by the market would tend to damp the decline in yields. With the change in strategy at its August meeting, the FOMC no longer lets its aggregate duration holdings flow back into the market. This approach allows long-term interest rates to adjust fully to a weakening of the economy, which should act to better stabilize the economy. Implementing the reinvestment policy So far, I have focused on the FOMC’s August policy decision; however, you may also be interested in the details of how the Desk has actually implemented the reinvestment policy. The instructions from the FOMC to the Desk, from both the August FOMC statement and the directive that was adopted at that meeting, were to keep the total face value of domestic securities held in the SOMA portfolio near their level at that time. The published size of the securities portfolio just ahead of the August meeting was $ trillion, so the Desk adopted this level as the target for the portfolio. This is a notable development by itself, as the directive from the FOMC now involved two targeted variables – the target range for the federal funds rate, and the target size for its asset holdings. To implement this directive, the Desk has been purchasing Treasury securities on a monthly schedule.