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MNI INTERVIEW: Earlier Fed Runoff May Avoid Yield Inversion

MNI (Washington)

Lessons from the Great Recession show that the order of the Fed's tightening moves matters, Kansas City Fed economist says.

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The Federal Reserve should consider beginning to shrink its balance sheet before raising interest rates or at least reducing it at a faster pace to forestall yield curve inversion as it tightens policy, a Kansas City Fed economist told MNI.

Market behavior in the aftermath of the Great Recession highlights that the order in which policymakers normalize monetary policy matters, said Karlye Dilts Stedman in an interview. Her research with co-author Chaitri Gulati indicates that raising the interest rate before reducing the size of the balance sheet could cause a flattening or inversion of the yield curve that can materially affect firms that profit from the spread between short- and long-term interest rates.

"Evidence also suggests that quantitative tightening, when you can isolate it from changes in the short rate, decreases term premium, and so the limited evidence that we have suggests offloading the balance sheet does in fact raise these long-term rates," she said. "If the FOMC had focused on a balance sheet first in normalization after the financial crisis then this headwind wouldn't have been quite so weighty on the long-end and it might not have ended up with inversion."

ARMED WITH RUNOFF

The KC Fed economist did not say how fast the balance sheet would need to be reduced in order to avoid yield inversion but suggested that if the economic outlook prevents runoff from starting earlier then another policy option would be to begin to carry it out in at the same time as hiking rates.

"It stands to reason that even if you started the processes in tandem it could still lead to less flattening than when the short rate is raised first," she said. "A faster pace of runoff would do more to raise the long rate."

"Even if you did not choose to normalize the balance sheet first you could use the balance sheet to combat inversion later," she said. "If the yield curve started to invert the Committee would be armed with the information to maybe start normalizing the balance sheet."

Fed officials this week said there have been no FOMC discussions yet about reducing the Fed's stock of securities, but they also stressed that they see more difficult tradeoffs ahead between the central bank's dual employment and price stability goals. Chair Jay Powell has led the FOMC toward a USD15 billion monthly pullback in asset purchases with the taper ending in mid-2022, but some including St. Louis Fed President James Bullard previously floated a faster taper, concluding in March, to give policymakers more flexibility to raise rates earlier if needed.

Governor Christopher Waller said Thursday, that if the FOMC wanted to, the central bank could shrink the balance sheet quickly in four to five years. "We can pull all this back. The maturity structure that we have, we did not go out into really long-dated securities in the last 18 months," he said, without offering preferences on a timeline. "There is no reason to keep it that big, so why not let it naturally run off as securities mature?"

WEIGHING ON LONG-TERM

Two factors could work to prevent a reduction of the balance sheet from steepening the yield curve, Dilts Stedman said.

Slower foreign growth will likely continue to depress long-term yields going forward, she said, and the Treasury Department has signaled that it will soon begin to reduce debt issuance, as lawmakers in Washington signal that they intend to emphasise raising revenues rather than borrowing to fund large infrastructure packages.­