MNI: Fed Asset Sales To Rein In Inflation Seen As Risky   ​

Some Fed officials favor using active sales of longer-dated Treasuries and MBS to fight inflation, but the potential for market disruption and political optics of possible losses for the central bank could keep such a plan grounded, former Fed staffers told MNI.

Many officials already favor eventually selling the Fed's MBS holdings in order to hasten the transition to a primarily Treasuries portfolio over the long run, but stubbornly high inflation and strong wage growth are emboldening some to call for asset sales to cool the economy in the nearer term.

Fed presidents James Bullard and Esther George have mentioned outright sales of longer term assets as an option if inflation doesn't moderate in response to the initial phase of rate hikes and passive QT.

After the January FOMC meeting, "given the subsequent strong employment and high inflation data, high retail sales, you’re hearing more urgency from many in terms of removing monetary stimulus," said Bill Nelson, former deputy director of the Division of Monetary Affairs at the Fed Board and current chief economist at the Bank Policy Institute.

"The comments from FOMC participants seem more focused on using the sales as a tool to reduce the size of the balance sheet, in particular to reduce the monetary stimulus from holding longer-term securities at a more rapid rate."

MARKET DISRUPTION

At its March meeting, the FOMC will likely lift rates from near-zero, pencil in another 100bps in hikes by December and release more details on its plan to shrink its USD8.9 trillion balance sheet.

The former officials said they expect the Fed to begin capping reinvestment of maturing assets soon after rates rise and to gradually increase those caps over several months to a number higher than the USD50 billion monthly pace reached in 2018.

At that point, "if it were to appear that inflation is not sufficiently contained by rate hikes, then the Fed will say and sincerely believe that selling securities is one of the tools they’re free to use and will use. I just don’t expect it to happen," said Stanford University finance professor Darrell Duffie, whose work on Treasury market reforms is often cited by Fed and Treasury leaders.

"The main reason to do it would be to raise long-term interest rates faster than would occur by short-term rate hikes. But this would be at the cost of potentially disrupting the secondary markets for these securities. The Fed would be willing to do that if push comes to shove but I just don't think push will come to shove."

LOSING MONEY

Joseph Wang, a former staffer at the New York Fed's trading desk, sees potential for market disruption even in the passive run-off phase, as QT increases supply of duration and takes away demand for longer-dated assets simultaneously. MBS sales later on would also lead to higher rate volatility.

Market disruption "is a tail risk," he said. “The Treasury market is systemically important. If there’s some kind of accident in the Treasury market I think they’d immediately stop QT. They could roll out QE or they’d pull out something like yield curve control to provide stability for rates."

Fed officials contemplated asset sales in 2010-2011 as part of their exit strategy ahead of QE3 but the idea was eventually set aside due to the potential political problem of explaining losses from unloading assets in a higher rates environment.

Now that the Fed holds even more longer-term securities and interest rates are potentially going to go up substantially faster, "the potential for making massive losses is very real," Nelson said.

"When making a decision on whether to sell, they would be very mindful of the politics behind explaining those losses. I think in the end that’s going to create a very high hurdle for them to use asset sales in the earlier parts of the normalization process as a means of reducing monetary stimulus."