The Fed Needs to Supply a Balance-Sheet Forecast
The lack of a balance-sheet forecast is becoming a glaring omission in the Federal Reserve’s quarterly Summary of Economic Projections and the omission is likely to be a continuing focus of investor interest and of uncertainty.
Fed Chair Janet Yellen and her colleagues clearly believe the large balance sheet is providing substantial accommodation to the economy. That is what she said during her most recent testimony to the Senate:
What we would like to do is to find a time when we judge that our need to provide substantial accommodation to the economy in the coming years is minimal.
The central bank also wants to be sure “that the economy is on a solid course and the federal funds rate has reached levels where we have some ability to address weakness by cutting it,” she added.
Reducing the balance sheet consequently removes that accommodation. That means the size of the balance sheet must be related to the policy makers’ assessment of the appropriate monetary policy to meet the Fed’s dual mandate.
Why then is the size of the balance sheet not an element of the Fed’s quarterly Summary of Economic Projections? The Fed does provide projections of the federal funds rate consistent with appropriate monetary policy. How do these rate projections relate to the size of the balance sheet? The two in theory are complementary, so that if the Fed begins balance-sheet reduction in the context of the median rate projection, the combined impact on accommodation should be greater than the rate increase alone. How is this incorporated into the Fed’s reaction function?
In short, the balance-sheet forecast (the size and the average duration of the assets) is the missing piece of the Fed’s SEP and central bankers don’t seem inclined to share this missing piece. This risks heightening uncertainty among market participants regarding the balance-sheet policy and the likely effect of that policy on the economy. The Fed’s guidance on the issue falls well short of its guidance on rate policy.
What makes this lack of information somewhat frustrating is that the Board of Governors staff prepares a balance-sheet forecast. Or, at least they did as late as 2011, and I think it reasonable to believe they still do (or, at a minimum, have the technology to do so). For example, this forecast of the balance sheet under alternative policies from the Dec. 8, 2011 Teal Book:
From the accompanying text:
All reinvestment is assumed to cease in April 2014, six months before the first increase in the target federal funds rate in the staff economic forecast, and then the balance sheet begins to contract. In April 2015, the Committee begins to sell its remaining holdings of agency MBS and agency debt securities at a pace that reduces the amount of these securities in the portfolio to zero in five years -- that is, by March 2020. The combination of no reinvestment and the sale of agency securities normalize the size of the balance sheet by September 2017.
Obviously, this forecast was upended by the subsequent weak pace of the recovery. But it shows that the Fed can make a forecast and probably has made a forecast. It just isn't sharing that information. Moreover, it is important information. Consider this from the most recent minutes:
In addition, it was noted that the downward pressure on longer-term interest rates exerted by the Federal Reserve's asset holdings was expected to diminish in the years ahead in light of an anticipated gradual reduction in the size and duration of the Federal Reserve's balance sheet.
Policy makers clearly see the balance sheet diminishing over time. But how is this impact weighed against the impact of raising short-term interest rates? This should be incorporated into the Fed’s reaction function, but this is not evident from the SEP.
What I fear is that although they have a forecast, they don’t really have much faith in that forecast. And worse, even though they have started talking about shrinking the balance sheet, they really don’t have much of a plan to accomplish that task. Again, from the most recent minutes:
Participants also generally agreed that the Committee should begin discussions at upcoming meetings about the economic conditions that could warrant changes in the existing policy of reinvesting proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities, as well as how those changes would be implemented and communicated.
It sounds like they are flying blind when it comes to normalizing the balance sheet. They don’t know when to do it, how to do it or what to say about it. So why keep talking about it as though it were about to happen?
Maybe they have a more concrete idea about the balance-sheet normalization process than it appears. But if they are not flying blind, they should provide a forecast so that investors have a full understanding of what is the expected level of accommodation appropriate to meet the Fed’s mandate. And if they are flying blind, maybe they need to just stop talking about normalizing the balance sheet. Doing so undermines their goal of clear communications and heightens uncertainty about the path of monetary policy. Without a plan, the chatter is beginning to look like for many Fed officials, normalizing the balance sheet is just an end in and of itself rather than a means to an end.
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