We purchased last year $300 billion in Treasuries, which was much less than 80 percent, and that total number brought us back to 790 or so billion, which is about where we were before the crisis. 

So at this point the Fed owns the smallest share of U.S. government as it had for many, many years. We are not monetizing the debt, and we have no immediate plans to do so in the future.

In response to a question about a market report stating that the Fed had bought 80% of the debt issued by the government.

Yes, I think that you're right that shrinking the balance sheet is akin to a monetary tightening...  You sell mortgages on the market, you're going to tend to raise mortgage rates, for example, and that will tend to tighten the housing market and slow the economy.

...

...We certainly don't want to hold this stuff 30 years. So the key here, I think, is, when we do come to the point we want to sell assets, is to do it in a gradual and predictable way so it has minimal impact.

Even when we get back to the pre-crisis balance sheet, we'll still be able to manage the short-term interest rate and the federal funds rate, much as we have in the past, so, if the economy needs stimulus, we'll still be able to do that. But we just won't be doing it through the balance sheet.

...

But, again, my expectation is that sales would be slow, gradual, announced in advance, and would not create undue market impacts. 

You mentioned adding insult by selling into a weak market. Of course, in a situation where we'd be selling, this would be one where we'd be trying actually to tighten policy because the economy was back on a growth track and we were trying to avoid future inflation risks.  So we wouldn't be doing that in a really weak economy.

During the Q&A session

Another uncertainty deserving of additional examination involves the effect of large-scale purchases of longer-term assets on expectations about monetary policy. The more we buy, the more reserves we will ultimately need to absorb and the more assets we will ultimately need to dispose of before the conduct of monetary policy, the behavior of interbank markets, and the Federal Reserve's balance sheet can return completely to normal. As a consequence, these types of purchases can increase inflation expectations among some observers who may see a risk that we will not reduce reserves and raise interest rates in a timely fashion.

We are also uncertain about how, exactly, the purchases put downward pressure on interest rates. My presumption has been that the effect comes mainly from the total amount we purchase relative to the total stock of debt outstanding. However, others have argued that the market effect derives importantly from the flow of our purchases relative to the amount of new issuance in the market. Some evidence for the primacy of the stock channel has accumulated recently, as the prices of mortgage-backed securities appear to have changed little as the flow of our purchases has trended down.

I don’t think that we have an exit problem. I think that we’re going to be able to manage our balance sheet down very, very smoothly. We have a new tool – the ability to pay interest on excess reserves, which means that the growth of our balance sheet is not going cause a problem in terms of future inflation. But other people have different views. And so the bigger our balance sheet gets the more people worry about that potential consequence. If that caused people to be worried about the inflation outlook, that would be counterproductive to our goals in terms of monetary policy.

[A]s our agency mortgage-backed securities purchases come to an end, we’ll probably see a little bit of upward pressure on interest rates. But there’s a big debate about whether they’ll be small or medium or large. So I think we’ll have to wait and see. Obviously, if mortgage rates were to back up a lot and if that had a big consequence for the economy then we very well could rethink the issue about whether we wanted to buy more mortgages.

Gharib: What is considered a lot?

Well I think we’re going to have to see the circumstances at the time. But most people who’ve thought about what’s likely to happen when we pull back from purchasing mortgage backed securities… they’re thinking that this is going to have a relatively small effect on the level of mortgage rates… something on the order of ½ to ¼ percent.

First, we have no shortage of tools for firming the stance of policy, and we will be able to unwind our actions when and as appropriate. Because we can now pay interest on excess reserves, we can raise short-term interest rates even with an extraordinarily large volume of reserves in the banking system. Increasing the rate we offer to banks on deposits at the Federal Reserve will put upward pressure on all short-term interest rates. In addition, we are developing and testing techniques for draining large volumes of reserves through reverse repurchase agreements and through term deposits at the Federal Reserve. And we can sell portions of our holdings of MBS, agency debt, and Treasury securities if we determine that doing so is an appropriate approach to tightening financial conditions when the time comes.

[W]e can sell portions of our holdings of MBS, agency debt, and Treasury securities if we determine that doing so is an appropriate approach to tightening financial conditions when the time comes.

For Treasury securities, the reduction in yields would occur through narrowing the term premium, or the expected excess return that investors receive for their willingness to take duration risk. By removing a considerable amount of duration through its asset purchases, the Fed has kept the term premium narrower than it otherwise would have been. In addition, the purchases of mortgage-backed securities remove prepayment risk from the market. Investors generally find it challenging to hold the negative convexity of MBS associated with prepayment risk, and hence they demand an extra return to bear that risk, which keeps MBS rates higher than they would otherwise be. The removal of a considerable amount of this risk by the Fed’s purchases would be expected to lower MBS rates by offsetting this effect.

One key issue in this regard is whether the market effects mentioned before arise from stock or flow effects. The portfolio balance effects discussed earlier would presumably be associated with changes in the expected stock of assets held by the public. Under this view, even an abrupt end to the Fed’s purchases, if fully anticipated, would not cause an adverse market response, as it would not represent a discrete jump in the outstanding stock of securities held by the public. However, we want to allow for the possibility that the flow of asset purchases, or the ongoing presence of the Fed as a significant buyer, may also be relevant for market pricing. In that case, the end of the Fed’s purchases could cause an increase in longer-term interest rates, at least temporarily until the market has had more of an opportunity to adjust to the Fed’s absence.

On theoretical grounds, it would seem that the main impact of the Federal Reserve purchases reflects stock effects. However, flow effects could matter as well, particularly given the very large MBS purchases we have been making. The bottom line is that we cannot be absolutely sure about the degree to which market effects arise through one channel or the other.

For that reason, the FOMC has adopted a strategy of gradually tapering the size of asset purchases as the programs approach their end. This is a cautious approach. It should help to smooth out any possible market reaction associated with the flow of purchases, and yet it has no cost under a stock-based view. Tapering gives the market time for new investors (or perhaps previously displaced investors) to enter the MBS market in the place of Fed purchases. A tapering strategy was applied to our Treasury purchases with success, as the end of that program did not prompt any notable market response—exactly as we had hoped. However, tapering may be a more important consideration for the termination of the MBS program, given its larger relative size.

Many of the Fed’s special credit facilities have been winding down at a rapid clip as financial markets have begun to function in a more normal manner. And my colleagues have come to accept the arguments I made regarding the necessity for the Fed to maintain its independence from the Treasury by not increasing its purchases of long-term Treasury securities. As to the Federal Reserve reducing its balance sheet so as not to monetize the excess reserves waiting to be converted to bank loans, I have been very clear: Given the lag between the time monetary policy is initiated and when it impacts the economy, that wind-down process needs to begin as soon as there are convincing signs that economic growth is gaining traction and that the lending capacity of the banking system is capable of expansion.

I am not alone on this front. I have faith my colleagues on the Federal Open Market Committee will stand and deliver in a timely way. And I expect that when it comes time to tighten monetary policy, my colleagues and I will move with an alacrity that, if needed, will be equal in speed and intensity to that with which we pursued monetary accommodation.

Our framework for {the large-scale asset purchase} aspect of our credit policies relied on preferred habitats of investors and imperfect arbitrage. There was ample evidence that private agents had especially strong preferences for safe and liquid short-term assets in the crisis; in those circumstances, sizable purchases of longer-term assets by the central bank can have an appreciable effect on the cost of capital to households and businesses. The marked adjustments in interest rates in the wake of the announcements of such actions, both in the United States and elsewhere, suggest that market participants also saw them in this light.

With the economy leveling out and beginning to grow again later this year, and with bank reserve demand ebbing as financial conditions improve, I will be evaluating carefully whether we need or want the additional stimulus that purchasing the full amount authorized under our agency mortgage-backed securities purchase program would provide.

St. Louis Fed President James Bullard, speaking to reporters in Little Rock, Arkansas, said “it might not be necessary” {to purchase the full amount of MBS by year-end}.

…

While purchasing the full amount of $1.25 trillion in mortgage-backed securities may not be necessary, “even if we stop short, it would be close,” Bullard, 48, told reporters after a speech.

As reported by Bloomberg.

I think what we’re going to have to do is sell off the mortgage-backed securities portfolio as appropriate when the time comes. That would be a difficult decision to make. It would put upward pressure on interest rates. You wouldn’t want to do it too soon, but that’s what we’re going to have to do in order to work down this very large set of assets that we have on our balance sheet… At some point in the future we may have to start selling off as appropriate.

As reported by Bloomberg Audio.