The Federal Reserve’s holdings of mortgage bonds play a pivotal role in how monetary policy influences the economy, according to a recent academic paper presented at a central bank research conference on Saturday. The study highlights how the Fed’s management of Treasury and mortgage bonds, in conjunction with its interest rate adjustments, significantly affects economic momentum.
The paper examines the impact of the Fed’s quantitative easing (QE) program, which involved large-scale purchases of Treasury and mortgage bonds starting in spring 2020. These purchases, initiated to stabilize the economy during the COVID-19 pandemic, led to the Fed’s total holdings more than doubling to approximately $9 trillion by mid-2022. Mortgage bond holdings specifically rose from $1.4 trillion in March 2020 to a peak of $2.7 trillion.
Mortgage bond purchases are particularly influential due to the critical role housing finance plays in the U.S. economy. However, quantifying the exact impact of these asset purchases has long been challenging, with some economists questioning their effectiveness.
The research, presented at the Federal Reserve Bank of Kansas City’s annual Jackson Hole symposium, quantifies the effects of the Fed’s mortgage bond buying. The authors estimate that both the Fed and private banks contributed to a 40-basis-point reduction in mortgage spreads during 2020-2021. This reduction, they argue, spurred a cumulative increase of $3 trillion in mortgage originations and $1 trillion in net mortgage bond issuance, with banks accounting for roughly half of this increase.
The study suggests these actions significantly boosted consumer spending and residential investment, underlining the powerful role of mortgage bonds in the Fed’s monetary policy toolkit.
The paper also discusses the ongoing process of quantitative tightening (QT), where the Fed reduces its balance sheet by allowing bonds to mature without replacing them. The Fed’s holdings have since decreased to $7.3 trillion, with mortgage bonds totaling $2.3 trillion. QT has progressed alongside the Fed’s now-paused interest rate hikes and is expected to continue even if rates are eventually cut. However, the sluggish housing market, exacerbated by high borrowing costs, has slowed the Fed’s ability to reduce its mortgage bond holdings.
Some analysts speculate that the Fed may need to resort to active sales of mortgage bonds to achieve its goal of holding primarily Treasury securities. This shift could mark a significant change in the Fed’s approach to managing its balance sheet and influencing the economy.
