MNI ANALYSIS: Fed Balance Sheet Reduction Begins Set Course

--Only 'Material Deterioration' in Outlook Could Force Fed to Resume

Reinvestments

By Jean Yung

     WASHINGTON (MNI) - Nothing less than a material shock to the U.S. economy

will cause the Federal Reserve to reverse course on its plan to taper asset

purchases, Chair Janet Yellen said Wednesday, underscoring the strength of the

Fed's determination to see the years-long program through.  

     That commitment could be tested in coming months as the European Central

Bank and others follow in the Fed's footsteps with their own plans to wind down

their balance sheets, draining liquidity from global financial markets. But Fed

officials, seeing signs the domestic economy will continue to expand at an

above-potential rate and improved economic conditions abroad, appeared confident

they have enough room to offset negative shocks. 

     In her quarterly question-and-answer session with reporters following a

two-day Federal Open Market Committee meeting, the Fed chair emphasized that

interest rate policy remains the Fed's "go-to tool" for managing moderate

shocks. Policymakers understand its effects on the economy and investors are

familiar with how the tool has been used. 

     "Our preference is, when we have two different tools that we could use to

actively adjust the stance of policy, to prefer and to make a commitment that to

the maximum extent possible, the federal funds rate will be the active tool of

policy," Yellen said. 

     "That is what we intend to use unless we think that the threat to the

economy is sufficiently great that we might have to cut the federal funds rate."

     Only a "material deterioration" in the economic outlook -- one that forces

the Fed to confront the possibility of returning rates to near-zero -- would

prompt policymakers to stop roll-offs from their balance sheet and resume

reinvestments, Yellen said. 

     "But as long as we believe that we can use the federal funds rate as a

tool, that is what we intend to do," she said. 

     Faced with "small changes in the outlook that require a recalibration of

monetary policy," the Fed could slow the pace of rate hikes over the medium

term, Yellen said, "but not, for example, change the caps on reinvestment."

Alternatively, she could imagine the Fed "continue reinvestment for a few

months, and then change it." 

     Clearly outlining its principles on policy tools offers greater clarity to

investors, Yellen said. But doing so also runs the risk of boxing the FOMC in to

a tightening course should the unwind be more disruptive than expected. 

     As the Fed has laid out, its caps on maturing securities that will not be

reinvested start small: $6 billion of Treasuries and $4 billion of

mortgage-backed securities per month. The combined monthly cap will then rise by

$10 billion at three-month intervals over the next 12 months until it reaches

$50 billion per month in October 2018. And in practice, the New York Fed has

projected that actual runoff amounts are not likely to reach these preset caps

in most months as less debt is due than the cap amount.

     In three years, the balance sheet could shrink to a level of $3.5 trillion,

the Fed bank projected. If the unwind continues, by 2023 the balance sheet could

be trimmed to $2.4 trillion. That ultimate size that the Fed deems "normal" has

yet to be determined and Yellen did not shed any new light on those

considerations Wednesday. The FOMC has said the normalization process will

continue until the Fed is "holding no more securities than necessary to

implement monetary policy efficiently and effectively."

     During the same period, the FOMC envisions interest rates rising gradually

to 2.9% by 2020, a year later than what policymakers expected in June. 

     Fed research suggests its balance sheet unwind could be roughly equivalent

to two rate hikes over the span of its multiyear program. 

     Officials on Wednesday also downgraded the longer run neutral fed funds

rate to 2.8% from 3.0% in June, reflecting "in some sense, a view that going out

many years, aggregate demand globally is likely to be weakened by continuing low

productivity growth and aging populations," Yellen said. 

     That implies current interest rates are already closer to longer run rates

than policymakers had thought a few months ago, meaning there is also less room

for them to rise. 

     But Yellen sounded certain that the course for the Fed's balance sheet

won't be the first to be scrapped under less positive circumstances. 

     "I would say that we're not locked in," Yellen said. "We believe that

economic conditions will evolve in a way that will warrant gradual further

increases in our federal funds rate target." If conditions evolve differently

than that, the Fed will "adjust policy as appropriate." 

     But, she continued, "the hurdle to changing our plans with respect to the

balance sheet in some sense is high." 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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