MNI: Fed Balance Sheet Policy Has Modest Impact -Paper

--New Research Shows QE Had Effectively No Effect on Long Term Yields

--Projects New Normal Size for Balance Sheet Around $3T 

--Dudley, Rosengren to Comment on Findings

By Jean Yung

     NEW YORK (MNI) - New research to be presented to Federal Reserve officials

Friday finds the effects of large scale asset purchase programs are likely more

modest than previously thought and that the Fed's balance sheet is likely to

stay large going forward. 

     With balance sheet policy having limited effect as an instrument for

monetary policy, the Fed's short-term benchmark interest rate remains its most

important and reliable policy tool, finds David Greenlaw of Morgan Stanley,

James Hamilton of the University of California at San Diego and National Bureau

of Economic Research, Ethan Harris of Bank of America Merrill Lynch, and Kenneth

West of University of Wisconsin and NBER.

     They are set to discuss their paper at Friday's annual U.S. Monetary Policy

Forum sponsored by the University of Chicago's Booth School of Business. Federal

Reserve Bank of New York President Bill Dudley and Boston Fed President Eric

Rosengren are slated to offer their comments on the findings. 

     --YIELD IMPACT 'EFFECTIVELY ZERO'

     A number of past studies have concluded that the three rounds of asset

purchases undertaken by the Fed in the wake of the Great Recession lowered the

10-year Treasury yield by about 100 basis points. But the authors examined how

10-year Treasury yields responded to Fed-related news and found that yields on

average moved little over the period. 

     While a lot of the rise in yields during the actual implementation of

quantitative easing can be attributed to news about the Fed, the bond market

only rallied on Fed news in the early stages of the first round of QE and

briefly in the run-up to the second round. On other days where the market

reacted to Fed news, investors sold off on average, the researchers found.

     "Over the whole period late 2008 to the end of 2017 -- including the

'entrance' through 2013 and the partial 'exit' thereafter -- the cumulative

change in 10 year yields was effectively zero," the authors said.

     What's more, last year, the Fed kicked off its transition to a smaller

balance sheet sooner than the market had expected, but the announcements and

implementation of the program do not seem to have affected rates much.

     "Our review suggests that large scale asset purchases have a more modest

effect on the bond market than many financial analysts and policy makers seem to

believe."  

     --$3T BALANCE SHEET

     Looking ahead, the Fed's balance sheet could fall to $3 trillion from

around $4.5 trillion at its max by the end of 2021 before reversing course,

owing to the growing demand for cash and the current "corridor" framework for

implementing monetary policy, the authors said. 

     The primary consideration in determining the ultimate size of the balance

sheet is the volume of excess reserves that is necessary in order to effectively

control the short term interest rate, which the authors estimate to be at least

$500 billion. 

     That is much greater than the $100 billion level in some scenarios

considered by Fed staff, but below other long-run scenarios offered by Fed

officials showing reserve balances settling in at $1 trillion. 

     "The FOMC should make a determination of the appropriate size of the Fed's

balance sheet over the long term and provide market guidance as soon as is

practical," the authors advised. 

     --POLICY RECOMMENDATIONS 

     In light of a larger "normal size" for the balance sheet, the composition

of assets is important, according to the paper. 

     The Fed has set increasing monthly caps for the amount of maturing

securities it would cease to reinvest every month, stating its asset arsenal

will eventually consist only of Treasuries. But a so-called "Treasury first"

approach to asset buying might be preferred so as to allow the Fed the option of

buying mortgage-backed securities in light of "likely low policy ammunition

around the next crisis," the authors said. 

     It also makes sense to consider larger and looser caps, possibly specified

in terms of quarterly rather than monthly changes, with caps perhaps removed

completely by 2019, in order to make a bigger dent in its pile of asset

holdings, the authors said.

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

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