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: