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Fed Officials Ready to Start Shrinking Portfolio in Months, By Nick Timiraos

WASHINGTON—Federal Reserve officials in June readied plans to start slowly shrinking the central bank’s large portfolio of bonds and other assets in the next few months, and the debate since then over when to launch the plan has increasingly pointed to September.

Several officials said the Fed had sufficiently prepared markets to initiate the run-off “within a couple of months,” according to the minutes of the central bank’s June meeting released on Wednesday. Some others said waiting longer could them give more time to figure out why inflation has slowed and that moving sooner might wrongly signal they were moving more aggressively to raise interest rates.

Taken together, the minutes of the June meeting and subsequent comments from Fed officials show a growing likelihood that the Fed will initiate its balance sheet runoff plan in September. That sequence would give officials more time to see if the inflation slowdown is temporary before raising rates, and it would allow officials to proceed well before any transition to a new Fed leader if Chairwoman Janet Yellen isn’t reappointed before her current term ends Feb. 3.

The Fed’s internal debate over the future policy path has been complicated by two puzzles. Inflation has weakened, justifying some officials’ call for a slower pace of rate increases.

But financial conditions have eased despite recent rate increases—with stock markets running to new highs, long-term yields declining and the dollar weakening. This has strengthened the resolve of those who want to stick with the Fed’s current rate path, which projects another quarter-percentage move this year and four more next year.

At the June meeting, officials discussed reasons why financial conditions haven’t tightened, including strong corporate-earnings growth and growing risk tolerance among investors. Some officials raised concerns that stock prices looked high and that subdued market volatility could lead to “a buildup of risks to financial stability,” the minutes said.

“The policy implication says, ‘Look we’ve been raising rates. We haven’t overly tightened financial conditions, so we can afford to continue here,’ ” said Roberto Perli, an analyst at research firm Cornerstone Macro LP. “It is a green light to continue, more than anything.”

Officials raised rates to a range between 1% and 1.25% at the June meeting, the central bank’s third quarter-point rate increase in as many quarters, and they penciled in one more increase this year. They also reached consensus on how they will gradually reduce the Fed’s $4.5 trillion asset portfolio, also known as its balance sheet, which could lead long-term rates to rise.

Because the Fed is prepared to gradually shrink those holdings in a slow, predictable manner, by allowing some assets to mature without reinvestment, officials last month said they expected launching the runoff would have a limited impact on markets, according to the account published Wednesday.

From a market standpoint, the Fed has “done everything to make the end of reinvestment as palatable as humanly possible,” said Jim Vogel, market strategist at FTN Financial.

Markets showed little reaction to the minutes Wednesday. The Dow Jones Industrial Average ended down 1.1 points, or 0.01%, to close at 21478. Yields on the benchmark 10-year Treasury note moved up after the release of the minutes but ended the day at 2.334%, according to Tradeweb, below Monday’s 2.352% closing yield.

The next Fed policy meeting is July 25-26. Ms. Yellen will have an opportunity to elaborate publicly on her outlook when she delivers semiannual testimony before Congress next Wednesday and Thursday.

The minutes showed officials also face divisions over how the portfolio runoff plans could alter the path of interest rates going forward. At the June meeting, officials’ median forecasts showed four more quarter-point rate increases in 2018.

The central bank’s discussion about the balance sheet picked up this year because Fed officials have grown more comfortable with the economic outlook. Officials stopped adding to the balance sheet in 2014, but they have been reinvesting the proceeds of maturing assets to keep the Fed’s holdings steady.

Under the plans announced last month, the Fed will allow its holdings to decline gradually by allowing a predetermined amount of bonds to mature every month without using the proceeds to buy more bonds.

It would start by allowing up to $6 billion in Treasury securities and $4 billion in mortgage bonds to roll off without reinvestment, and let those amounts rise each quarter, essentially setting a speed limit for the wind-down. The plan’s pace would ultimately rise to a maximum of $30 billion a month for Treasurys and $20 billion a month for mortgages.

Fed officials have said they want the balance-sheet wind-down to run quietly in the background, meaning they are unlikely to adjust it from one meeting to the next, barring a shock to the economy.

Officials raised rates last month despite some concern over declines in inflation gauges, which Ms. Yellen and others have largely attributed to one-off factors such as big discounts on wireless phone plans. The Fed’s preferred inflation gauge briefly surpassed the central bank’s 2% target in February but posted greater-than-expected drops since then, rising just 1.4% on the year ended in May.

Officials will receive two more monthly inflation readings before their September meeting and are likely to study those reports closely to confirm their latest forecasts. They could face greater doubt or division on their policy path if current trends continue—inflation remains soft, the unemployment rate falls further and asset prices continue their rise.

Before the release of the June meeting’s account, traders in futures markets placed a 19% probability on a Fed rate increase by September, and nearly a 60% probability of at least one rate increase by year-end, according to CME Group.

The Fed’s legal mandates are to ensure prices are stable, measured in recent years with the 2% inflation objective, and to provide maximum sustainable employment. But officials pay close attention to financial conditions, including corporate and government bond yields and asset prices, because those serve as the transmission mechanism for the Fed’s rate-setting policy.

Looser financial conditions could strengthen the argument of those who want to move faster on the balance sheet runoff.

“If financial conditions aren’t responding as much as the Fed expects to changes in the interest rate, and if that’s because the Fed has a large balance sheet, you might want to reduce the balance sheet sooner to see how markets respond,” said Josh Wright, chief economist at iCIMS, a provider of hiring software, and a former analyst at the New York Fed.

 

Write to Nick Timiraos at nick.timiraos@wsj.com

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