Thoughts about the Fed’s Balance Sheet

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Many investors and observers are keen to see what the FOMC minutes say about the Fed’s balance sheet.  We suspect that the expectations for fresh insight may be disappointed.  The indications from the Fed’s leadership is that discussions are still in preliminary stages.  Most of the comments about the desire to begin reducing the balance sheet came from the regional presidents rather than the Board of Governors.   

When asked during her recent testimony Yellen barely went beyond what has already been said.  There are four points:

First, the reducing the balance sheet will take place after the normalization of interest rates is well under way.  This is an example of strategic ambiguity.  It is revealing sort of, without precision.  Many suspect that when as the Fed funds target range moves above 1.0%, officials will get more serious.

Second, the most likely first step is to stop recycling proceeds from maturing issues.   Last year, the Federal Reserve bought roughly $216 bln of Treasuries it reinvested funds that were freed up from the maturing issues.

Third, the long-term goal is to return the Federal Reserve’s balance sheet to only Treasuries.  Currently, the Federal Reserve owns roughly $1.75 trillion of mortgage-backed securities.

Fourth, Yellen indicated in her recent testimony that the Fed did, in fact, want to reduce the balance sheet over time, but did not want it to be policy tool.   She had previously suggested that if the $177 bln of maturing Treasuries were allowed to run-off this year, it would be tantamount to around a 50 bp increase in rates.

The Federal Reserve owns $425 bln of Treasuries that will mature in 2018 and another roughly $350 bln that mature in 2019.    If the process is allowed to run its course, the tightening will swamp the use of the Fed funds target range as the primary tool of monetary policy.

Another implication of reducing the Fed’s balance sheet is that it will boost the federal government’s debt servicing costs at a time when interest rates may already be rising.  Consider that the Federal Reserve is the largest owner of US Treasuries.  That means it receives large coupon payments. Last year, it returned nearly $100 bln of the federal government, which was about 40% of the net debt servicing costs.

An important known unknown is the configuration of the Federal Reserve.   We have argued the Fed’s independence is safe because rather than eroding it, President Trump will be able to name a majority of Governors over the next year or so.  There are two vacancies now, and Tarullo has announced plans to step down in Q2.  That means Trump can nominate three of the seven-person board this year.  Next year, both Yellen and Fischer are likely to step down.

Some of Trump’s economic advisers have been critical of the Fed and QE.  The argument is that it is a significant encroachment on fiscal policy.  There was also some talk during the campaign that the balance sheet should be reduced.     However, the operational challenge of during so may be more formidable than campaign rhetoric can acknowledge.   Also, we note that some of the more stridently unorthodox positions, including support for NATO, naming China as a currency manipulator on day one, not recognizing one China, have been walked back.

During the Great Depression, the central government’s balance sheet was discovered.  For most high income countries most of the time, deficits are routine, and debt levels rise inexorably.  During the Great Financial Crisis, government balance sheets swelled, but the political will to do so indefinitely did not materialize in sufficient force.  Instead, the central banks’ balance sheets came in to play.    We suspect this will be a semi-permanent development.  What is unorthodox at one moment in time sometimes becomes the new orthodoxy later.   It may be easier to put toothpaste back in the tube then take power away once it is conceded.