Alarm Over the Fed's $4.45 Trillion Balance Sheet Is Silly
The Federal Reserve is laying the groundwork for shrinking its $4.45 trillion balance sheet. But don’t panic yet, bond traders. This isn’t 2013.
A parade of speakers --- Fed Chair Janet Yellen, Governor Lael Brainard, and San Francisco Fed President John Williams -- is clearly priming the market for a future statement that says “the FOMC decided to reduce the reinvestment of principal payments” from its balance sheet holdings. Why now? Does 50 basis points of interest-rate increases mean the central bank is “well under way” toward rate normalization and can now justify holding the proceeds from bonds that mature rather than funneling the cash back into the economy by way of further bond purchases?
By itself, 50 basis points doesn’t push very deep into normal territory. But the Fed is looking forward to another 75 basis points of tightening this year, for a total of 125 basis points, or 1.25 percentage points. Still not much of an increase -- except that the definition of “normal” changed dramatically over the past year. The median estimate of the neutral federal funds rate has fallen in recent months from 3.8 percent in June 2015 to 3.1 percent now. It was 4.25 percent back in January 2012.
The drop in the expected terminal point for policy changes the definition of normal, which then changes the timing of balance sheet normalization.
Yellen estimates that the impact on financial conditions of ending reinvestment of principle payments during 2017 would be a 15 basis-point increase in 10-year Treasury yields, equivalent to two 25 basis-point increased in the target fed funds rate. But those who remember the infamous “Taper Tantrum” of 2013 may disagree and fear a much larger response from bond traders. Recall that yields jumped 100 basis points in the months after then Fed Chairman Ben Bernanke’s hinted at ending quantitative easing. I wouldn't expect a repeat.
First, the Fed in recent weeks has been pushing this message with no apparent market reaction. So expectations appear to be more in line with Fed communications compared with 2013. Second, and probably more importantly, the economy of 2013 was very different from now. Part of the reaction to Bernanke’s warning reflected the fact that the economy remained far from full employment. Was the Fed dramatically more hawkish than believed? Now, however, the economy is near full employment with the tightening cycle already under way. Hence, balance sheet action seems appropriate, whereas in 2013 it appeared to be jumping the gun.
Investors may also fear, reasonably, that balance sheet reduction threatens the economy. It would be additional tightening on top of rate hikes. The Fed will be stepping back from the market just as the federal government looks poised to ramp up bond sales to finance tax cuts and spending increases. And reducing the size of its mortgage bond holdings may upend the housing recovery.
Such concerns are reasonable. There is a risk that the Fed, playing with two tools at once, will tighten too quickly, and in reality it shouldn't be in a rush to reduce the balance sheet. That said, the central bank tends to react fairly nimbly to changing economic conditions. It has repeatedly delayed action in response to deteriorating economic or financial conditions. I would anticipate the same approach with regards to balance sheet reduction.
If yields jump excessively, financial conditions would worsen more than anticipated, or economic activity would slow, then the Fed would step back from balance sheet normalization. It may even abandon the idea entirely. The pace of action remains dependent on economic outcomes, just like the pace of any future rate hikes. The economy speaks, the Fed listens.
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