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

Sarah Foster, Bankrate.com on

Published in Home and Consumer News

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.”

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