Fed's Bullard Knows His Treasury Yield Curve
Having tipped their toes in the water with two interest-rate hikes -- and more expected to come -- the Federal Reserve officials have begun the discussion about reducing the size of the central bank’s $4.45 trillion balance sheet. To date, they have tended to look at interest rate-policy as separate from balance-sheet policy. Once the former is heading toward normalization, then they can begin the latter.
I tend to be skeptical of that strategy, largely because it risks financial destabilization by flattening the yield curve, or the difference between short- and long-term bond rates. I would prefer an explicit policy strategy that incorporates both interest-rate and balance-sheet tools acting jointly not with the goal of “normalizing” either of those components, but aimed at meeting the Fed’s dual mandates of full employment and stable prices. Under such a framework, for example, the Fed wouldn’t need to follow through with additional rate hikes before to balance-sheet reduction. There would be no preconceived notion of the “correct” order of operations.
That’s why I like what I heard in St. Louis Federal Reserve President James Bullard’s most recent speech. His model differs from that of his colleagues. He sees the economy as stuck in a “low-safe-real-rate regime” and forecasts it will remain in there over the near term. He owns the infamous bottom dot in the Fed’s December Summary of Economic Projections, predicting a policy rate of just 75 basis points to 100 basis points through 2019.
In Bullard’s analysis of the 2017 economy, he isn’t ready to change that basic assessment. And early data suggests that his colleagues are more likely to move in his direction than vice-versa. The lack of inflationary pressures suggests the Fed can remain on hold in March with little risk of subsequent overheating.
But Bullard still sees the balance sheet as a mechanism to normalize policy even if policy rates remain low. The problem with the current policy stance is that the Fed is flattening the yield curve by raising expectations of higher short-term rates while a large balance sheet places downward pressure on long rates. Bullard doesn’t see a theoretical justification for maintaining this twist operation as the Fed responses to changing economic conditions. He adds:
Ending balance sheet reinvestment may allow for a more natural adjustment of rates across the yield curve as normalization proceeds.
What Bullard is looking for is a policy approach that lifts the entire yield curve rather than one that flattens the curve. Such a policy approach would alleviate concerns such as those of New York Federal Reserve President William Dudley:
An important aspect of current financial market conditions is the very low bond term premia around the globe … if term premia and bond yields were to remain low and the economic outlook suggested that financial conditions needed to be tighter and a rise in short-term rates did not generate this outcome, then the FOMC would likely need to raise short-term rates further than anticipated. The 2004-07 tightening cycle might be a good example of this. The FOMC ultimately pushed the federal funds rate up to a peak of 5.25 percent, in part, because the earlier rise in short-term rates was generally ineffective in tightening financial market conditions sufficiently over this period.
Bullard’s point is that the existence of a large balance sheet mitigates this problem. Financial accommodation doesn’t need to be eased via the policy rate exclusively. Fed Chair Janet Yellen sees this, too:
The downward pressure on longer-term interest rates that the Fed’s asset holdings exert is expected to diminish over time--a development that amounts to a ‘passive’ removal of monetary policy accommodation. Other things being equal, this factor argues for a more gradual approach to raising short-term rates.
Bullard is building on Yellen by saying not only is that diminishment justification for a gradual pace of rate increases, but as a replacement for rate increases. There is nothing to stop them from initiating such policy now.
I don’t see broad support at the Fed for shifting toward balance-sheet policy just yet. Bullard appears to be an outlier. For the most part, monetary policy makers seem content with in the order they have established. Rates first, then balance sheet. But the realization is growing that they need to unify interest-rate and balance-sheet tools in their policy approach as the time to utilize the latter approaches. In effect, they will be targeting both the level of rates and the slope of the yield curve. It does not yet appear, however, that they have a consistent framework to unify these tools. It is tough to communicate what you don’t know, which will leave Fed speakers at a loss to explain how the two tools will be applied in practice. Watch for the Fed to start building such a framework this year.
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