Portfolio duration

What Should the Fed Own?

The Federal Reserve began to consider just how far its balance sheet consolidation should go well before the tapering actually began nearly a year ago. Earlier staff analyses pointed to a gradual runoff of long-term debt that could take years to reduce Fed assets to a new long-run equilibrium. More recently, market observers have speculated about an early end to consolidation that would result in a higher steady-state level.

Yet, as a recent Wall Street Journal article highlights, policymakers and analysts have devoted less attention to the mix of assets that the Fed should select once the balance sheet shrinks to its long-run equilibrium and policymakers allow it to expand slowly—say, in line with the increase of demand for currency.

In this post, we argue that the Fed should aim in normal times—when the economy is expanding and absent any financial strains—for a portfolio that has minimal liquidity, maturity and credit risk. In practical terms, this means that their portfolio should be composed largely of Treasury bills and short-term notes, with an average maturity that is very short….

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Banks and interest rates: be careful what you wish for

Many people seem to think that – as a new BIS working paper concludes – banks benefit when monetary policy tightens and interest rates rise (especially from a low level). Do they? In some instances, perhaps, but as a general principle, surely not.

A casual glance at recent U.S. stock market behavior seems to support the idea that higher interest rates would be good for banks now. When the Federal Open Market Committee decided not to hike interest rates on September 17, the S&P500 dropped by 1.85% over two days, while the KBW index of bank stocks fell by 4.85%. A week later, when Fed Chair Yellen speaking about inflation dynamics expressed her continued expectations for a rate hike this year, the S&P500 edged lower, but the bank index rose by nearly 2%...

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