This Federal Reserve policy you’ve never heard of could have the biggest effect on your wallet

The Federal Reserve is making headlines by raising interest rates at the fastest pace in a single year since the 1980s, concerning investors and consumers alike with fears the central bank could go too far, too fast.

But it’s another lesser-known decision — albeit a substantially more complex one — that could have an even greater influence over how expensive it is to borrow money. And it’s all coming to a head this month.

Over a three-month period, the Fed has been letting $47.5 billion worth of assets every 30 days roll off its massive near-$9 trillion bond portfolio, more formally known as the balance sheet. But starting in September, the Fed kicked the process up a notch, doubling how many Treasury and mortgage-backed securities it’s rolling off to $95 billion.

Why does the Fed’s shrinking balance sheet matter?

It’s the antithesis to the Fed’s massive bond-buying campaign during the coronavirus pandemic. Across three different programs, the Fed amassed almost $4.6 trillion worth of assets such as Treasurys and mortgage-backed securities. Those moves bolstered liquidity and kept the system awash with credit, helping push interest rates on products the Fed normally doesn’t directly control — including on things like mortgages and student loans — to rock-bottom levels.

But what goes down must come back up. Experts say shrinking the balance sheet could be just another lever that pushes interest rates higher. That’s because the endeavor effectively reduces the money supply and the availability of credit in the financial system.

This month’s ramp up could be one of the many factors behind the 30-year fixed-rate mortgage barreling to 6.12, the highest level since November 2008, according to national Bankrate data. One indication of just how much extra tightening the Fed’s balance sheet run-off is providing: The spread between the 10-year Treasury yield and 30-year fixed rate mortgage is almost a full percentage point higher than it should be, according to Lawrence Yun, chief economist at the National Association of Realtors.

“With the Fed being one big liquidity provider and no longer being there, it’s making mortgage rates even higher,” he says.

It’s a sacrifice the Fed is willing to make to help cool the rapid inflation that’s spent six straight months at levels not seen since the 1980s. The process is often dubbed quantitative tightening.

“It’s also another way in which the Fed is pressing on the brakes in an effort to slow the economy and reduce inflation,” says Greg McBride, CFA, Bankrate chief financial analyst. “Over time, this is going to be more impactful than raising short-term rates.”

The move would have major implications for how much it costs consumers to finance major life-events, from buying a home or car to attending college.

If things go according to plan, the Fed will have removed more than $522 billion from the financial system by the end of 2022 and another $1.1 trillion by the end of 2023. Trimming $1.5 trillion off the Fed’s portfolio is the equivalent of hiking interest rates by up to another 1 percentage point, according to estimates from Luis Alvarado, vice president and investment strategy analyst at the Wells Fargo Investment Institute.

“We understand what the Fed did at the height of the pandemic in March 2020 when everyone was scared,” Alvarado says. Fed officials, however, don’t want to “have big balance sheets. They want to have balance sheets that are running in parallel according to economic growth.”

How much will interest rates rise as the Fed trims its balance sheet?

The big question mark is whether officials will have enough room on the runway to get there.

The Fed has only ventured down this road once before: when the economy was recovering from the Great Recession of 2007-2009. Back then, they managed to vacuum just about $700 billion out of the system, only 20 percent of what they bought, before financial markets seized up and the economy risked taking a nosedive.

At the Fed’s current pace, the Fed’s balance sheet would reach its pre-pandemic size of $4.3 trillion roughly four years from June 2022. But a lot can change in the economy by then — and a lot can also go wrong enough for Fed officials to abort the mission.

So far, the Fed has gotten rid of about $133 billion bonds. Investors will likely be holding out for more clues from the Fed at its remaining rate-setting meetings in 2022 for more clarity on how far officials think they can take the process.

“I don’t think the Fed can pull too many trillions of dollars out of the system without something going bump in the night,” McBride says. “If the economy is weakening, then they’re going to eventually start to ease up on policy or the pace of quantitative tightening.”

The Fed’s inflation-fighting plan is unlike any other in recent history

The Fed’s last foray into shrinking the money supply was also much different than today’s experience, another layer making it unclear just how much consumers could feel an impact. The Fed waited almost two years to start dumping bonds after it hiked interest rates for the first time after the financial crisis in December 2015. This time, the Fed waited just three months after its first rate hike to start reducing its holdings.

Not only that, but officials previously chose to gradually increase how many bonds they’d let roll off their portfolio over a 12-month period, until it eventually hit $50 billion a month. Today, the Fed is moving four times faster and its monthly cap is nearly twice the size.

Have the biggest rate increases already happened?

In an unprecedented move, mortgage rates lept in large increments in just a short period of time. That’s largely because the 10-year Treasury yield — the main benchmark for the 30-year fixed rate mortgage — has also soared.

A year ago, the benchmark 30-year fixed-rate mortgage was 3.03 percent, while the 10-year Treasury yield was 1.31 percent. Typically, the spread between the two should be about 170 basis points, National Association of Realtors’ Yun says.

Today, however, the key bond yield is at 3.45 percent, the highest since 2011, 267 basis points above the average 30-year fixed rate mortgage.

It signals that the sub-5 percent mortgage rates that consumers have been able to take advantage of for more than a decade — besides for an eight-week stretch in 2018 — are all but in the rearview mirror, according to McBride.

“When the biggest buyer in the market walks away from the table, it creates a void,” he says. “There has to be investors to fill that void, otherwise prices could fall sharply and rates could rise notably in order to attract enough investor demand.”

It’s too soon to tell what exactly happens with interest rates from here, but some experts say the biggest leaps might have already happened, evident by the fact that increases in the Fed’s benchmark fed funds rate are now catching up to the jump in mortgage rates.

“We know the Fed will continue to tighten, both on the fed funds rate as well as the unwinding of quantitative easing,” Yun says. “But hopefully the market has already priced all that in, so maybe this time next year, mortgage rates will be the same, even as the Fed continues to tighten policy.”

The 10-year Treasury rate could fall even if the Fed is hiking rates, especially if investors see an economic slowdown or lower inflation ahead. The key rate erased nearly half of its gains during the Fed’s previous tightening cycle, beginning with the Fed’s first rate hike on Dec. 16, 2015 and ending when officials stopped shrinking the balance sheet on Sept. 30, 2019. Technically speaking, it only rose 62 basis points.

“That’s what happens most of the time when the Fed is tightening policy,” McBride says.

Other factors that could affect interest rates

The consumer impact also depends on more technical reasons. When the Fed shrinks its balance sheet, it doesn’t sell those securities; instead, it simply lets those bonds roll off at maturity without reinvesting its principal payments.

Yet, some experts have pointed out that the Fed might have trouble hitting the quota it set for mortgage-backed securities. In that case, they might have to outright sell those assets for the first time in Fed history, which would have even bigger implications for mortgage rates. The Fed’s massive stockpile of those securities — $2.7 trillion — has no doubt prevented the cost of financing a home from rising even more.

And interestingly enough, only $43.6 billion worth of Treasury securities are maturing this month, meaning the Fed will have to turn to $16.36 billion worth of shorter-term Treasury bills to hit its full monthly cap.

Fed officials indicated in records of both the January and March Fed meetings that this strategy “might be appropriate at some point in the future,” so the Fed can move toward having a longer-run bond portfolio “primarily of Treasury securities.” Key Fed officials have also said the approach could be an even more aggressive backup plan if inflation remains high.

Selling any assets also opens up the Fed to another risk that it’s so far been able to dodge: taking a loss.

Bottom line

Less money sloshing around in the financial system broadly tightens financial conditions. That might prompt businesses to delay any new investments — including hiring. The worst-case scenario is a tick-up in joblessness.

All of that shows, the Fed’s shrinking balance sheet is a major factor to watch moving forward — and also a reason to concentrate on building up your emergency fund.

Another group caught in the crossfire could be investors. The Fed’s plans to unwind its balance sheet has contributed to the year’s choppy financial conditions, with the S&P 500 down more than 19 percent to start the year.

Keep a long-term focus and tune out the noise: The Fed’s overarching goal is to get monetary policy on track to a more sustainable level, one that paves the way for a long and sustainable expansion and flushes the massive price pressures out of the financial system.

Still, the Fed’s balance sheet drawdown is a major unknown, and only in hindsight will investors and consumers be able to judge its full impact.

“This is the Wild West of monetary policy,” says Kristina Hooper, chief global market strategist at Invesco. “We are in the land of experimental monetary policy. We just don’t know how this is going to play out.”