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The Federal Reserve’s extensive holdings of mortgage bonds have a significant impact on how monetary policy influences the broader economy, according to a new academic paper set to be presented at a central bank research conference on Saturday.
The paper examines how the Fed’s strategic use of Treasury and mortgage bond holdings, alongside interest rate adjustments, plays a crucial role in steering economic momentum. This approach, known as quantitative easing (QE), was employed aggressively by the Fed beginning in the spring of 2020. As a result, the central bank’s total assets surged, doubling to a peak of approximately $9 trillion by mid-2022, with mortgage bond holdings increasing from $1.4 trillion in March 2020 to a high of $2.7 trillion.
Mortgage bond purchases are particularly impactful due to the central role of housing finance in the U.S. economy. However, the effectiveness of these asset purchases has been a subject of debate among economists and central bankers, with some questioning their overall value.
The paper, authored by a group of economists for the Kansas City Fed’s annual Jackson Hole research conference, provides quantitative insights into the effects of the Fed’s mortgage bond buying program. It highlights the collaborative role of private banks in this process.
“We find that banks and the Fed were each responsible for about a 40-basis point reduction in the mortgage spread during 2020/21,” the authors wrote. “This led to a cumulative increase in mortgage originations of about $3 trillion, and net mortgage bond issuance of about $1 trillion, with banks responsible for about half of this increase.”
The paper underscores that these actions had a significant impact on consumer spending and residential investment, illustrating the powerful influence of the Fed’s mortgage bond holdings on economic activity.
The influence of mortgage bonds is also evident in the Fed’s current strategy of quantitative tightening (QT). Under QT, the Fed has been gradually reducing its balance sheet, shrinking its total assets to $7.3 trillion, with mortgage holdings now at $2.3 trillion. This process involves allowing bonds to mature without replacing them, and it has been conducted alongside the Fed’s now-paused interest rate hikes. QT is expected to continue even if the Fed begins to lower interest rates, although the timeline for its conclusion remains uncertain.
The QT process has progressed more slowly than anticipated, largely due to the sluggish state of the housing market amid high borrowing costs, which has reduced mortgage creation and, consequently, the Fed’s ability to offload mortgage bonds. Some experts believe that the Fed may eventually need to resort to actively selling mortgage bonds to achieve its goal of holding primarily Treasury bonds.
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