How Fed Fights Next Downturn Hangs on Smooth Balance-Sheet ExitBy
Fed officials see return to zero as likely in next recession
QE in Fed toolkit risks political fracas over fiscal trespass
Federal Reserve officials intend to start the delicate task of drawing down their $4.5 trillion balance sheet as early as this year. Goal No. 1 will be to get the ball rolling without making a mess of markets in everything from U.S. mortgages to emerging-nation debt.
There’s something else at stake, however. The central bank’s very ability to use large-scale asset purchases -- otherwise known as quantitative easing, or QE -- to fight future recessions may hinge, in part, on how gracefully they pull back from their record level of holdings.
And that’s no small detail. According to many economists and some policy makers, it’s only a matter of time before the Fed will want to reach for its balance sheet again.
“Getting this right without disrupting markets is going to be key for them,” said Lee Ferridge, senior macro strategist for North American at State Street Corp. in Boston. “We know we’re in a low-rate environment for the long haul and you have to expect you’ll revisit this in the future. If they mess it up, it would certainly do damage to QE as a policy tool.”
Investors will probably learn more about the latest Fed thinking on the balance-sheet exit strategy when minutes of its meeting last week are published on May 24. New York Fed President William Dudley, speaking Thursday in Mumbai, assured his audience the U.S. central bank will “pursue this with great care and caution in the months ahead.”
“We want this very much to run in the background, to be a very modest, minor event,” he said.
The Fed went 95 years -- spanning the Great Depression, two world wars and multiple recessions -- without resorting to bond purchases. It may seem odd that Fed officials are keen to retain a tool so rarely needed in the past, and one that proved highly controversial. Many Republicans in Congress saw QE as an unwelcome foray into fiscal policy, and some of the same lawmakers will almost surely object if the Fed repeats the strategy.
For Boston Fed President Eric Rosengren, pondering another round of QE is simply a matter of accepting economic reality and recognizing the shortcomings of other policy options when interest rates hit zero.
For starters, he says, the majority of Fed officials expect the federal funds rate to rise no higher than 3 percent in the longer-run due to low growth and low inflation in developed economies around the world. He also notes that recessions over the past 60 years have prompted the Fed to drop rates, on average, by more than 5 percentage points.
A recent paper from Fed staff economists Michael Kiley and John Roberts estimated that in the current economic environment the Fed’s policy rate will be at, or very near, zero as much as 40 percent of the time.
“It is inevitable we’re going to be talking about the balance sheet expanding in future recessions, in fact in most recessions unless they’re very, very mild,” Rosengren said May 5 during a panel discussion at Stanford University.
Rosengren isn’t alone among Fed policy makers with that opinion. St. Louis Fed President James Bullard, speaking on the same panel, called it a “distinct possibility” the Fed will need to resort again to QE. In a May 8 interview with Bloomberg News, Cleveland Fed chief Loretta Mester said QE “should be part of the tool kit” for use when the Fed hits zero and the economy needs more support.
Not that QE is the only option when rates hit zero. Indeed, it’s widely assumed the Fed would first resort to a tactic it used during the Great Recession known as forward guidance. It involves making a clear commitment to keeping rates at zero for an extended time, which helps longer-term rates settle lower. But that’s unlikely to make the difference in a typical recession.
The Fed might also follow a path tried by some European countries by pushing their policy rate below zero. Another approach would be to raise the Fed’s 2 percent inflation target. If effective in raising inflation, that would boost the neutral level for interest rates, making a zero policy rate more stimulative.
While each approach has its proponents in and outside the Fed, neither has gained enough traction among policy makers to use any time soon, according to Carl Tannenbaum, chief economist at Northern Trust Corp. and a former senior staffer at the Chicago Fed.
“The example of negative rates has proven to be less than encouraging,” he said. “Additionally, if they are struggling to create any kind of inflation, raising the target isn’t going to have the same credibility with the market. That’s further down the list” of options the Fed might try, he said.
None of that, however, will remove the political hostility to QE.
“I have that concern the Fed will respond once again with QE,” Representative Andy Barr, a Kentucky Republican who serves on the House Financial Services Committee, said in an interview. “They are conflating here the role of monetary policy with fiscal policy through private credit allocation and taking excessive risk.”
Barr said he’s not opposed to QE as a “a last resort tool” under extreme circumstances, and concedes that the first round of bond purchases by the Fed in 2008 had, in his view, “some limited stimulative effect.” But if rates hit zero and the economy still needs a jolt, Barr said it’s up to Congress to provide counter-cyclical fiscal stimulus, preferably through tax cuts.
“I think the Fed is better off when it sticks to its primary purpose, which is price stability,” he said.
Others are skeptical Congress will act quickly enough to provide meaningful fiscal relief in a recession, and the Fed may feel forced to act with asset purchases. Lawmakers can’t stop that, but they can react in a punishing fashion. There are already various pieces of proposed legislation floating around Capitol Hill that would curb the Fed’s authority and independence in monetary-policy making. At the moment they lack sufficient support to pass, but that could change.
“The problem for the Fed is that its reputation has not really had a chance to rebound from criticism it took in the wake of the crisis,” said Sarah Binder, a senior fellow at the Brookings Institution in Washington. “That will leave the institution more vulnerable.”