Heed the Fed's Balance Sheet Banter
The changing of the political guard in Washington shouldn't overshadow some radical developments happening across town at the Federal Reserve, where it's as if the doves have donned hawks’ feathers and flown the coop.
Consider Fed Governor Lael Brainard, who as recently as September was expected to dissent against a majority on the Federal Open Market Committee in the event they voted to raise interest rates. So, it's difficult to conceive why four months later, in a January 17 speech at the Brookings Institution, she was open to not only boosting rates more rapidly, but in reversing the long-held doves’ policy stronghold of reinvesting the proceeds of maturing securities held by the Fed on its balance sheet into more bonds.
And yet, she uttered these words: “If fiscal policy changes lead to a more rapid elimination of slack, policy adjustment would, all else being equal, likely be more rapid than otherwise, with the conditions the FOMC has set for a cessation of reinvestments of principal payments on existing securities holdings being met sooner than they otherwise would have been.”
The financial markets have rightly shifted to "DefCon 1'' in light of what they construe to be a threat to the de facto agreement that’s been in place between bond market participants and the Fed for almost three years: Don't shrink the balance sheet and we won't tank the bond market. Remember the "taper tantrum'' of 2013 that roiled markets and sent bond yields shooting higher when then Chairman Ben S. Bernanke suggested the Fed could pull back from its bond purchases?
New York Fed President William Dudley has been the primary proponent of maintaining a large balance sheet, which has grown to $4.46 trillion. Dudley had the hawks fuming at the irony of his May 2014 comments that "delaying the reinvestment puts the emphasis where it needs to be – getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.”
That watershed moment gave way to a new way of thinking about the aggregate supply of bonds in the market. If the Fed was capable of maintaining a large balance sheet via reinvestment while at the same time normalizing rates, one could begin to think of balance sheet holdings as permanently retired, expunged, extinguished. In time, the mindset would be that supply had been permanently reduced.
It’s one thing to be wholly data dependent; it’s another to hint that inflation could rise faster than anticipated; it’s yet another to suggest fiscal stimulus could open the door to a steeper path to normalization. But it’s anathema to cross a line in the sand that’s been established as firmly as any good gentlemen’s agreement.
``Reinvestment'' is as fighting a word as there’s ever been when it comes to abruptly tightening financial conditions. Fed officials may as well open the door and invite in a recession given the current fragile economic expansion is at the precipice of being the third longest in postwar history.
Fed hawks are likely raging that the doves are talking about changing the supposed order of actions required to begin unwinding the era of unconventional monetary policy. Indeed, coercing the hawks into agreeing to successive rounds of quantitative easing entailed being in agreement that ending reinvestment would be the first order of business followed by normalizing interest rates.
The incoming administration and Congress should consider themselves warned of the dangers of doves in hawks’ clothing.
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Danielle DiMartino Booth at Danielle@dimartinobooth.com
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