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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 $1 trillion. 
     "The FOMC should make a determination of the appropriate size of the Fed's
balance sheet over the long term and provide market guidance as soon as is
practical," the authors advised. 
     --POLICY RECOMMENDATIONS 
     In light of a larger "normal size" for the balance sheet, the composition
of assets is important, according to the paper. 
     The Fed has set increasing monthly caps for the amount of maturing
securities it would cease to reinvest every month, stating its asset arsenal
will eventually consist only of Treasuries. But a so-called "Treasury first"
approach to asset buying might be preferred so as to allow the Fed the option of
buying mortgage-backed securities in light of "likely low policy ammunition
around the next crisis," the authors said. 
     It also makes sense to consider larger and looser caps, possibly specified
in terms of quarterly rather than monthly changes, with caps perhaps removed
completely by 2019, in order to make a bigger dent in its pile of asset
holdings, the authors said.
--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com
[TOPICS: MMUFE$,M$U$$$,MT$$$$]

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