Some of the big questions looming about the Fed’s exit strategy are if, when, and at what pace the Fed should draw down its huge portfolio of mortgage backed securities (MBS). At its meeting last week the Federal Open Market Committee announced that it is continuing its MBS purchases at a “gradually slowing pace,” but that will still leave $1,250 billion in MBS on its balance sheet at the end of the first quarter. Another, more long-term, question is whether such price-keeping operations—a term used by Peter Fisher who once ran the trading desk at the New York Fed—should be a regular part of monetary policy in the future. Brian Sack, who now runs the trading desk, concludes in a recent speech that they should be.
The answer to these important questions requires on an empirical assessment of the impact of the MBS purchase program. Unfortunately, publicly available assessments are sorely lacking. For this reason, Johannes Stroebel and I undertook an econometric study of the impact; the study is part of a larger research project by us and our colleagues on central bank exit strategies.
Such an assessment requires that one carefully consider other influences on rates on mortgage backed securities. We focused on two obvious ones: prepayment risk and default risk. If we control for prepayment risk using the swap option-adjusted spread, which is regularly used by MBS traders and investors, and if we control for default risk using spreads on senior or subordinated agency debt, we find that that the program has not had an economically or statistically significant effect on mortgage spreads. If we use other measures to control for prepayment and default risk we can see statistically significant effects, but they are small. Even in these cases it was the announcement or the existence of the program, rather than the size of the portfolio that mattered for spreads. We find that there is no statistically or economically significant effect of the size of the portfolio, a finding which we show is quite robust. If our estimates hold up to scrutiny, they raise doubts about such price-keeping operations and suggest that the Fed could gradually reduce the size of its portfolio without a significant impact on the mortgage market.
The graph illustrates our findings. It shows the swap option adjusted spread (with its prepayment risk adjustment) in red and the predictions of that spread using the agency debt spread (a measure of risk) in blue. The residual between these two, shown in green at the bottom of the graph, indicates that there is little left for the Fed’s MBS portfolio to explain. Details and other cases are in the paper.