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The Federal Reserve is keen to reduce its balance sheet more aggressively in the face of soaring inflation, despite seeing quantitative tightening as an uncertain tool with likely only a small impact on price pressures compared to raising interest rates, former Fed officials told MNI.
"A faster move on portfolio policy takes pressure off having to raise rates more quickly," said former Fed Board of Governors research director David Wilcox, now an economist with the Peterson Institute for International Economics and Bloomberg Economics.
"The theory is QE causes longer-term interest rates to be lower than they otherwise would be, so the simplest and most reasonable hypothesis is, roughly speaking, the reverse also holds" for QT, he said. But, “nobody really knows, because we’ve only run this experiment once in modern economic history."
Some former officials estimated the effect of shedding several trillions of dollars of assets to be marginal, at just 20 bps to 40 bps of tightening.
Daniel Sichel, who spent more than 20 years at the Fed Board of Governors, noted the marginal effect of QE gets smaller over time as the balance sheet gets bigger. "So unwinding it probably does have a relatively small direct effect on rates and therefore on inflation," but "the effect is modest."
NOT ON AUTOPILOT?
Officials' desire to use QT as a direct tool for monetary tightening "conflicts a bit with the FOMC’s view that the federal funds rate should be the primary tool of monetary policy," former New York Fed President Bill Dudley told MNI.
The wind-down process could also be bumpy if the Fed is open to adjusting QT more readily in this cycle, he added.
"What would be consequential is if they think of QT as more an active tool — not just running on autopilot in the background once it is started," he said. "Fed officials know they are far behind the curve, so starting the balance sheet runoff earlier is not a problem since they are highly confident that they’ll get above a 1% fed funds rate relatively quickly. Also, it allows you to do more a bit more quickly, perhaps."
With the Fed set to signal a March liftoff of interest rates as soon as next week (see MNI: Fed Could Give Nod to March Hike This Month-Ex-Officials), several FOMC officials have called for the central bank to shrink its balance sheet soon after liftoff and at a faster pace than it did post-financial crisis. Atlanta Fed President Raphael Bostic suggested a pace of at least USD100 billion per month, twice the peak rate in 2018.
One argument for a faster QT comes from the concern expressed by some economists that the sheer size of the balance sheet, at roughly USD8.7 trillion, could put enough downward pressure on the long end of the yield curve for it to possibly invert if rate hikes bring up the short end.
"The picture is asymmetric. Markets have little visibility on rate hikes after the next two years, so the curve won't steepen too much without help from the Fed," said Derek Tang, an adviser with former Fed Governor Larry Meyer's Monetary Policy Analytics group.
"One way to control the risk of yield curve inversion is to say we’re going to start balance sheet runoff. As the size of the balance sheet goes down, downward pressure on the long end will start to cease."
Michael Bordo, a former Federal Reserve Board and Bank of England visiting scholar, said QT should have started much earlier so the FOMC can focus on rate hikes.
"I don't think QT has the same degree of effects on spending and the factors that affect inflation," he said.
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