MNI:Fed Aims For Slow Balance Sheet Runoff To Keep Market Calm

Federal Reserve officials are coalescing around a gradualist, highly telegraphed approach to reducing its USD8.7 trillion balance sheet, though debate on the extent and pace of runoffs and eventual sales is still incipient, ex-Fed officials and staffers told MNI.

“They’re not going to take too much of a risk of disrupting markets because they don’t want to cause a liquidity squeeze,” said Randall Kroszner, a former Fed governor, in an interview.

Policymakers are uncertain about the market effects of quantitative tightening -- and still smarting from turbulent prior attempts to substantially reduce the amount of reserves in the banking system.

“The last thing they want to do is have to go back in and start buying assets because they started putting them on the market too quickly, ” Kroszner said.

He thinks the Fed will tighten monetary policy in at least five of its remaining seven meetings this year, though one or two of those moves may relate to balance sheet announcements.

Jeffrey Lacker, former president of the Richmond Fed, said the Fed’s acknowledgement of the relatively weak effects of balance sheet policy would reinforce the argument for moving as glacially as possible -- even though his own hawkish propensities might suggest a more aggressive course.

“They may now view asset purchases as having only a marginal effect on market rates, and if so they are likely to delay running off the portfolio,” said Lacker.

“Add to that the extent to which some observers have attributed the temporary bobble in repo markets in September 2019 to the small earlier decline in Fed asset holdings, and the Fed is likely to be exceptionally cautious about reducing the overall size of its portfolio.”

Ex-officials and staffers declined to specify a runoff rate at this point and market estimates vary quite widely -- from a terminal pace of just USD60 billion per month all the way to USD100 billion per month.

RANGE OF VIEWS

Atlanta Fed President Raphael Bostic has come out as the most hawkish on the balance sheet, calling for a rapid monthly reduction of USD100 billion. Kansas City Fed President Esther George also recently outlined the ways in which the Fed’s efforts at gradualism may be tested.

“More aggressive action on the balance sheet could allow for a shallower path for the policy rate,” George told the Economic Club of Indianapolis. “Alternatively, combining a relatively steep path of rate increases with relatively modest reductions in the balance sheet could flatten the yield curve and distort incentives for private sector intermediation.”

While the debate over how to implement a new balance sheet exit strategy is just beginning, the two hawks are still in a minority. The last time the Fed wound down its balance sheet in 2017, officials allowed assets to run off at USD10 billion a month, gradually increasing the pace to USD50 billion a month over the course of a year. By mid-2019, with insurance rate cuts looming, the Fed ceased its rundown.

Raphael Schoenle, former deputy director of the Cleveland Fed’s Center for Inflation Research and a professor at Brandeis University, thinks balance sheet policy is just not ready for primetime in terms of being used strategically and surgically as a tightening tool.

“Before we see any strong innovation, I think policymakers will be very cautious to put this into development,” Schoenle said.

Victor Li, a former senior Atlanta Fed economist now at Villanova University, said the Fed must proceed with caution.

“Scaling back Fed owned long-term Treasuries and mortgage backed securities will have a greater impact on mortgage rates and hence the housing market," he said. "It is well known that residential investment is a leading economic indicator.”