Fed Mortgage Bond Holdings Play ‘Central’ Role in Policy, Paper Says

By Michael S. Derby

Federal Reserve holdings of mortgage bonds are deemed to play a "central" role in shaping how monetary policy influences economic momentum, according to research presented at a central bank conference.

The paper explores how the Fed adjusts its holdings of Treasury and mortgage bonds to complement changes in its interest rate targets, collectively designed to impact the economy’s momentum. This approach, known as quantitative easing (QE), began in earnest in the spring of 2020. The Fed’s acquisitions of Treasury and mortgage bonds resulted in its balance sheet more than doubling, peaking at approximately $9 trillion by the summer of 2022. Specifically, Fed holdings of mortgage bonds surged from around $1.4 trillion in March 2022 to a maximum of $2.7 trillion.

The Fed’s mortgage purchases are particularly significant, considering how crucial housing finance is to the U.S. economy. Nevertheless, economists and central bankers have often grappled with accurately assessing the impact of these asset purchases, and skepticism about their value persists.

In the paper presented at the Kansas City Federal Reserve’s annual research conference in Jackson Hole, a group of economists quantified the effects of the Fed’s mortgage buying and elucidated the mechanics involved, noting the role of private banks. The authors concluded, “We find that banks and the Fed were each responsible for about a 40-basis point reduction in the mortgage spread during 2020/21.” This reduction led to a total increase in mortgage originations of approximately $3 trillion and net mortgage bond issuance of around $1 trillion, with banks contributing to about half of this increase. "These effects had a large impact on consumer spending and residential investment," they added.

The influence of Fed holdings on monetary policy also extends to a process known as quantitative tightening (QT). As part of QT, the Fed has reduced its balance sheet to $7.3 trillion, with mortgage holdings currently at $2.3 trillion, allowing bonds to mature without replacement. QT has progressed alongside a recent series of interest rate hikes and is expected to continue even if the Fed lowers rates, although the timeline for the end of QT remains uncertain.

QT’s advancement has been slower than anticipated, partly due to a sluggish housing market and high borrowing costs, which have decreased mortgage creation and hindered the Fed’s efforts to offload mortgage bonds from its balance sheet. There is speculation that the Fed may need to actively sell mortgage bonds in the future to achieve its goal of primarily holding Treasury bonds.