The Federal Reserve's balance sheet
The Federal Reserve's balance sheet - a return to the good old days
After almost a decade of the unconventional since the global economic crisis, is it time to return to the conventional? The Federal Reserve (Fed) has already begun one leg of its journey back to normal by raising interest rates from almost zero. Now, it is preparing the second and most perilous part of the journey – unwinding the $4.5 trillion of bonds it holds on its balance sheet.
Central bank action in the past decade has been unprecedented, so there is no manual to guide the Fed on this journey. The process of normalization will be a balancing act. If they perform the feat correctly, they will have successfully intervened in the market in an extraordinary way, with little consequence. Yet, the fallout could be dramatic if the Fed gets it wrong by reducing the balance sheet too much, too fast, or without properly communicating the process to the market.
How did we get here?
In 2008, as the U.S. economy was faltering and flirting with deflation, the Fed cut its policy interest rate sharply to near zero, prompting the central bank to look at more unconventional measures. To reduce long-term interest rates in 2009, the Fed purchased large amounts of U.S Treasury and mortgage backed securities (MBS), financed by equally large increases in reserve balances.
There were changes to the rate setting operations too. Prior to 2008, before asset purchases started, the Fed managed the fed funds rate by changing the quantity of reserves in the system. But with the large quantity of reserves available, small changes in the supply of reserves no longer suffice to control the funds rate. The Fed now influences rates primarily by varying the interest rate it pays banks on their reserves (known as interest on excess reserves or IOER). To further improve its control of interest rates, the Fed now also allows other private-sector institutional lenders, such as money market funds, to earn fixed interest rates on cash held for short periods with the Fed, through a program known as the overnight reverse repurchase (RRP) program.
Since starting asset purchases, the balance sheet has roughly quintupled, rising from around $900 billion to about $4.5 trillion currently (comprised of about $2.5 trillion of U.S. Treasurys and $1.7 trillion of government guaranteed MBS). The balance sheet is currently equivalent to around 23% of GDP. The Fed stopped increasing its stock of financial assets in October 2014, but it maintained the stock by reinvesting the principal from maturing bonds. Recent MBS purchases, for example, have been between $20 billion to $30 billion per month – buying that represented some 21% of issuance in March.
Change is upon us
Now, improving growth prospects, diminishing slack, and rising inflationary pressures mean that the economy is ready for less monetary accommodation. The Fed raised interest rates in March and is expected to hike twice more this year, potentially more if the labor market overheats. However, increasing policy rates does not appear to be sufficient. The Fed has indicated that it will soon start to reduce the size of the balance sheet, believing that both the growth outlook and the financial system are sufficiently strong to deal with this financial tightening. Fed Chairwoman Janet Yellen noted in her testimony before Congress in February that she anticipates “a balance sheet substantially smaller than at the current time.”
How will it do this? Details are still scant. Nevertheless, we know that the Fed’s intention is to reduce the balance sheet passively by ceasing the reinvestment of maturing securities. In this way, the balance sheet will shrink “naturally.” The minutes of the Federal Open Market Committee’s (FOMC) March meeting also revealed that the Fed intends to phase out reinvestments by introducing monthly limits on how much asset run-off will be allowed each month. These caps will also be adjusted higher each quarter. At this stage, however, we do not know the sizes of those caps.
Nearly all the FOMC are looking for normalization to start this year. I believe it will be at the end of 2017 or early next year; only once they have raised policy rates at least two more times. After all, it is prudent to delay the beginning of normalization until short-term interest rates are comfortably away from zero. If shrinking the balance sheet leads to more tightening of financial conditions than expected, or if the economy slows for some other reason, then being further away from the lower bound on interest rates would give the FOMC more scope to respond. Assuming the Fed raises interest rates twice more this year, the fed funds rate will reach around 1.5% by year end.
The FOMC will likely give more details on their plans at each forthcoming meeting, and provide clear guidance of timing and operational details at its September meeting. Clearly communicating their plans to the market will be paramount.
Communication is almost everything
The Taper Tantrum in 2013 is a good example of how important communication is. In May 2013, former Fed Chairman Ben Bernanke’s words at a hearing of the Joint Economic Committee caused major market disruption when he “loosely” announced the idea that quantitative easing (QE) would end in “the next few meetings.” Yet when the Fed’s strategy was stated more clearly – explaining that asset purchases would be reduced only gradually – there was minimal effect of the tapering. The same could be true of balance sheet reduction if communication is clear and transparent.
Communicating the Fed’s policy will be easier if they clearly specify how the balance sheet will be reduced. Market disturbance will also be lessened. Providing details in advance of the cap sizes would meet this requirement. The Fed clearly appreciates the importance of transparency. Accordingly, John C. Williams, President and CEO of the Federal Reserve Bank of San Francisco, said the Fed’s approach to normalizing monetary policy will be gradual, open, and “the most telegraphed monetary policy of our lifetimes.” Specifically, once the shrinkage begins, it should continue without interruption.
Attempts to actively manage the unwinding process, for example by reducing it at a faster pace if inflation picks up more than expected, could lead to unexpectedly large responses in financial markets. Balance sheet reduction should tick along in the background, not the foreground.
Being able to communicate to the market what the terminal size of the balance sheet the Fed is aiming for would also minimize disruption. At this stage, however, there is significant debate about what that terminal size will be. There are even strong proponents of keeping the balance sheet large. Some of these voices are extremely well-known and very well-respected. In a recent blog post, former Fed Chairman Ben Bernanke stated his case for keeping the balance sheet unchanged. He makes three strong points:
- A large Fed balance sheet would enhance financial stability. There is strong demand from financial institutions for safe, liquid short-term assets and this demand will only grow with regulatory change. When there aren’t enough low-risk assets available, the private sector tends to step in to supply them. However, such instruments can cause crises — short-term private debt was central to the meltdown in financial markets. As a result, it is better if the Fed is able to meet the demand for low-risk assets, which is only possible if it maintains a large balance sheet.
- A larger balance sheet which incorporates the RRP program could improve the transmission of monetary policy. Banks tend to only partially or gradually pass on changes in the funds rate to depositors and borrowers, which dampens the impact of monetary policy. However, by accepting deposits from non-bank institutions and paying them the RRP interest rate, the Fed could ensure that its interest rate decisions are transmitted directly to them and the economy.
- A large balance sheet could strengthen the Fed’s lender of last resort function. During a panic when depositors lose confidence, they tend to drain their funding from financial institutions. If a central bank has a large balance sheet, it can replace that missing liquidity, and calm the panic by swapping risky assets on financial institutions’ balance sheets for safe Treasury securities from its own holdings. During the financial crisis, it was notable that U.S. financial institutions were hesitant about borrowing from the Fed because they were concerned about being perceived as “weak.” But if the Fed were to maintain a large balance sheet permanently, permitting banks to borrow from the central bank as a norm, the stigma of borrowing from the central bank would be reduced.
Former Fed Chairman Bernanke has many supporters. They argue that if the economy needs tighter financial conditions, steeper interest rate increases could do the job. They also point out the uncertain impact on financial conditions of a decrease in the balance sheet. Why then has the Fed made it clear that tightening of monetary policy will ultimately involve shrinking the balance sheet?
A return to the good-old days!
Quantitative easing has never been embraced by the masses. Many believe it was an inappropriate, unnecessary policy with several adverse side effects. For example, excessively low interest rates have triggered a search for yield, leading to riskier investment behaviour. Many governments and central bankers have expressed concerns about bubbles, imbalances, and distortions caused by these policies. Low rates have, arguably, widened the income distribution and adversely affected savers.
There have also been public policy concerns about the Fed intervening in particular sectors and allocating credit. In addition, with its large asset holdings, the Fed may face increased risk of financial losses, which can ultimately affect the government’s overall fiscal position.
Finally, QE is considered by many as a deviation from the more rule-like monetary policy that was in play in the 1980s and 1990s. Several economic studies suggest that moving to this more discretionary type of policy has increased the volatility of the dollar and other exchange rates.
There is growing pressure on the Fed to return to more strategic and traditional monetary policy. A key advocate, renowned economist Dr John Taylor, believes that unconventional policies and the departure from rule-like policy is the reason why economic growth has been consistently below the Fed’s forecasts of late. He also believes that QE is the reason why economic growth has been much weaker than in previous U.S. recoveries from deep recessions.
At the recent 2017 Milken conference in Los Angeles, I shared a panel with Dr Taylor and we discussed the case for more rule-like policy. He believes that the policy implication of the sub-par economic recovery is clear: monetary policy should be normalized and the Fed balance sheet reduced. The Fed should transition to a predictable rules-based monetary policy like the one that worked in the past, while recognizing that the economy and markets have evolved. Notably, Taylor has been shortlisted for the position of Fed Chairman at the end of current Chairwomen Janet Yellen’s term next year.
From the Fed’s perspectives, the arguments against QE and, by association, a large balance sheet are convincing – yet perhaps the balance sheet need not return to its pre-crisis size. The FOMC’s November 2016 minutes indicated sympathy for “a balance sheet that was much smaller than at present, though likely at least somewhat larger than in the years before the financial crisis, reflecting trend growth of balance sheet items such as currency as well as a larger supply of reserves.” The growth in the public’s demand for currency is certainly one reason that the Fed will need a larger balance sheet indefinitely.
Clearly, details on the operational framework for implementing balance sheet normalization still need to be revealed. Just as QE was one of the most important monetary policies to be introduced, reversing it will also be a ground-breaking policy. As Chairwoman Janet Yellen nears the end of her term early next year, and assuming her term is not renewed, she will want to leave a strong legacy. Successfully lifting interest rates off their near zero range and beginning balance sheet normalization would be a remarkable legacy, if it does not prematurely end the economic recovery currently underway.