Last week, the Federal Reserve’s Open Market Committee voted to reduce the amount of bond purchases that it makes under its quantitative easing program (QE3) by $10 billion in July. This will reduce the Fed’s monthly purchase amount to $35 billion, which is significantly lower than its one-time peak of $85 billion each month. By purchasing bonds from financial institutions, the Federal Reserve increases the amount of capital in the financial system and this leads to lower long-term interest rates. Quantitative easing has been instrumental in stimulating the economy during the past few years, but with the economy now on the mend, the Fed has begun winding this program down. As this occurs, long-term interest rates should increase, raising the cost of borrowing for both consumers and businesses. However, even after the Fed completely winds down its QE3 program, the holdings that it purchased under the program will still have the ability to affect long-term interest rates for some time.

The Fed Begins Debating Principal Reinvestments

The Federal Reserve is currently on pace to completely wind down its QE3 program by this fall; however, even after it is no longer making original purchases of fixed securities under the program, it will still receive payments from maturing securities on the vast amount of holdings that it already has. So far this year, the Fed has received roughly $16 billion on average each month in payments from maturing securities, and it currently reinvests these payments in order to maintain the size of its holdings which have grown to record levels and now exceeds $4 trillion. With QE3 on pace to end in a few months, the Fed has to decide if it should continue reinvesting these payments or stop doing so. Back in 2011 the Fed indicated that it would stop reinvesting these payments after winding down its quantitative easing program and would allow the size of its holdings to decrease, but now some members of the central bank are questioning this strategy. For example, William C. Dudley, the president of the Federal Reserve Bank of New York said last month that “Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions, as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the committee’s intention.” Furthermore, some Fed officials have argued that the effect of bond buying on interest rates is determined by the size of the Fed’s total holdings, not the size of its monthly purchases. These members believe that continuing to reinvest principal payments would keep long-term borrowing costs low and preserve the effect of the QE3 program, even after the program has been completely wound down and original bond purchases are no longer being made. So the question becomes what to do with these funds: Should the Federal Reserve continue to reinvest them and maintain the size of its holdings or stop doing so and let its holdings decrease?

This is uncharted territory for the Fed as its balance sheet continues to grow and now exceeds $4 trillion. Reinvestments are another form of stimulus and some Fed officials will undoubtedly share Mr. Dudley’s view that they should continue while the economy regains its footing, while others are likely to be more hawkish and will push to end them entirely, or at least in part. We will learn more about members’ views as the year goes on. In the meantime, while QE3 remains in effect and principal payments are still being reinvested, senior housing participants who are interested in taking advantage of the low interest rates that this program helps to generate should contact the successful financing firm Cambridge Realty Capital to learn more about the differentfinancing options that it offers for growth, acquisitions, and other needs as well.

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