As a method of normalizing monetary policy, the Federal Reserve is planning a gradual liquidation of its massive portfolio of US Treasury and Mortgage Backed Securities (MBS). The rationale is that employment gains have been steady and averaging over 200,000 jobs per month. The core inflation rate (ex the volatile food and energy components) has also been hovering near 2%, which is the Fed’s inflation target. Putting more fixed income assets like Treasuries and MBS back into the market is one way of raising interest rates. If there is more supply on the market, all other things being equal, the price should go down. If the price of a fixed income asset goes down, the yield or rate goes up.

Once the wind-down is mostly or partly complete, if the economy falters, the Fed can then start buying again. We know of no studies that predict how far up long-term mortgage rates will have to go as the Fed liquidates its holdings. Our expectation is that they will keep some fixed income on its balance sheet so that it will have some gunpowder to shoot in either direction. They can sell more if the economy starts to overheat and the inflation rate exceeds the 2% target. At the same time, with a lower asset balance, they can start buying if the economy is not growing enough. The Fed is like any other player in the capital markets: it does not care to make big bets on the direction of the economy. Rather, the Fed wants to be able to respond to whatever the market and the economy do. Of course, the Fed is different because their policy and actions can and will impact how the market and the economy behave. The Fed can be thought of as a counter-force, a force that attempts to moderate the economy. Markets tend to overreact and the Fed can counter an overreaction. In our view, the Fed has generally been successful in fighting inflation and keeping the economy from slipping into a depression.