Markets need to start worrying about a key change in Fed policy

Janet Yellen. (Photo by Win McNamee/Getty Images)
  • The Fed’s plan to shrink its balance sheet gradually may have greater market impact than expected.
  • The planned $US450 billion reduction in the Fed’s assets between last month and the end of 2018 could be equivalent to a full percentage point interest rate hike, according to the Council on Foreign Relations’ Benn Steil.
  • That’s a lot more than markets are pricing in, and it could lead to turbulence, he says.
  • St. Louis Fed President James Bullard tells us why he believes the effect of bonds rolling off the balance sheet will be much smaller than that of the original purchases.

The US Federal Reserve officially decided earlier this year to split its exit strategy from unprecedented monetary stimulus into two distinct parts: one is a gradual reduction in the $US4.5 trillion balance sheet that’s more or less on autopilot, while the second is a more active, data-dependent increase in interest rates.

There’s just one problem — these two separate silos may only exist in the Fed’s abstract world of forecasts.

In reality, selling bonds from the central bank’s portfolio, or allowing maturing securities to roll off the balance sheet, pushes interest rates higher just like, well, pushing interest rates higher.

Benn Steil, director of international economics at the Council on Foreign Relations, thinks Fed officials and financial markets are seriously underestimating the amount of monetary tightening that will result from the central bank’s scheduled asset reduction.

Fed Chair Janet Yellen has “stressed that the Fed sees its balance-sheet reduction as a primarily technical exercise separate from the pursuit of its monetary policy goals — in particular, pushing inflation back up to 2%,” Steil writes in an opinion piece for Business Insider. The Fed has been undershooting its inflation target for much of the economic recovery despite sustained anemic economic growth of around 2%.

“But is Yellen right that the Fed’s gradual approach to balance-sheet reduction makes it relatively unimportant in its impact on monetary conditions?” Steil asks, in a piece co-written with his colleague Benjamin Della Rocca. “Our analysis suggests that it will be, in fact, considerably more important than the market, or the Fed itself, realises.”

Steil uses the Fed’s own estimates about the effects of bond buys, and estimates that the planned $US450 billion balance sheet reduction through the end of 2018 “is roughly equivalent to a one per cent hike in the policy rate.”

Chart 1 fed balance sheet reduction through 2018

This time is different?

So what’s the Fed’s basis for thinking things will be different on the way out than they were on the way in, when the Fed was purchasing Treasury and mortgage bonds to keep long-term borrowing costs low and spur investment and spending during and following the Great Recession?

In a recent interview with Business Insider, St. Louis Fed President James Bullard argued that there is a key difference: signalling. When the Fed was buying bonds, it was also sending a signal about how much longer official short-term rates would remain at zero. This had a signalling effect for markets that amplified the impact of bond purchases, Bullard said.

By detaching bond buys from the process of rate increases, the Fed hopes to have neutralized this signalling effect. That is, a continued roll off of bonds from the balance sheet says little, for now, about the future path of interest rates.

“Now you start to wind down the balance sheet, it doesn’t signal anything, because you’re not signalling what you’re going to do with the policy rate anymore,” Bullard said. “So there is a way to think about it that would suggest that when you’re buying it does have important effect, but when you’re allowing it to shrink it really doesn’t have that much of an effect.”

Fed balance sheet BI

The Fed ultimately embarked on three rounds of quantitative easing, more than quintupling the size of its balance sheet to $US4.5 trillion. Fed officials have not yet stated an end goal for the optimal, eventual balance sheet size, but some have suggested it will be somewhere around $US2 trillion, considerably larger than the prevailing pre-crisis size of $US800 billion.

Yellen herself has admitted the Fed has entered uncharted territory because it “does not have any experience in calibrating the pace and composition of asset redemptions and sales to actual prospective economic conditions.” In addition to starting the process of balance sheet unwind, the Fed has raised interest rates four times since Dec. 2015, to a range of 1% to 1.25%.

For Steil, the central bank is just being characteristically overoptimistic about its ability to manage interest rate policy smoothly. Recent history supports his view.