Several US Federal Reserve officials have recently floated the idea that the central bank will begin to shrink its $US4.4 trillion balance sheet, perhaps as early as this year, in an effort to tighten monetary policy and start to reverse some crisis-era decisions.
It’s a bad idea.
The economy, while growing, remains fragile, registering a mediocre 1.9% annualized pace of expansion in the fourth quarter. The job market, while improving, is still a far cry from its heyday before the financial crisis, with many Americans still underemployed or out of the labour force entirely. And inflation, the other key portion of the Fed’s mandate, continues to undershoot the official 2% inflation target.
Moreover, the rise of Donald Trump to the US presidency has introduced all kinds of uncertainties. Will he spend money on infrastructure? Cut social spending? Reduce taxes for the rich? Start a trade war? Start an actual war? Nobody knows, including Fed officials. It’s little wonder Fed staffers have shown a tendency to be less optimistic than their bosses.
The stated rationale for reducing the Fed’s holdings of mortgage bonds, by ceasing reinvestment of the principal on maturing bonds, is straightforward: The Fed sharply expanded its balance sheet initially as a response to the financial crisis and then as a way to beef up an unusually soft economic recovery.
In the process, it helped prevent another Great Depression, particularly given a Congress that was unwilling to act on some of President Barack Obama’s bolder fiscal stimulus proposals.
Through purchases of longer-dated Treasury and mortgage bonds in a process known as quantitative easing, the Fed more than quadrupled its total asset holdings. But the outcomes were generally beneficial, and none of the side effects that worried more hawkish central bankers — sudden inflation spikes, flagrant market bubbles, emerging-market crises — have come to pass.
As the economy gets back to normal, the thinking goes, it’s time to move away from policies once thought of as emergency measures.
It’s all relative
Morgan Stanley economists, who believe the Fed will cease mortgage bond reinvestments starting in April 2018, appear to make the case against the policy in a research note.
“The passage of time helps the normalization process,” they write. “As nominal gross domestic product expands, the footprint of the balance sheet shrinks relative to economic activity.” In other words, if the central bank just does nothing, in a growing economy, the scale of the bond holdings will become relatively smaller on its own.
The chorus has become sufficiently loud to prompt Ben Bernanke, the former Fed chairman who is now a hedge fund adviser, to chime in on his Brookings Institution blog, coming out strongly against any deliberate Fed action on the balance sheet.
The current policy says the Fed intends to leave the balance sheet untouched until “normalization of the level of the federal funds rate is well under way.”
“The case for deferring action on the balance sheet until short-term rates are meaningfully higher remains at least as strong as it was when the FOMC’s strategy was first devised,” Bernanke argued, referring to the Fed’s policy-setting Federal Open Market Committee.
He’s right. With the economy still wobbly, there’s no reason to rock the boat further. The whole reason for using the balance sheet as an active tool in the first place was the fact that official interest rates were already at zero and couldn’t go any lower. That’s simply not the case as the Fed reverses direction, so better stick to the tried-and-true policy tool as opposed to risking needless market turmoil through excessive experimentation.
This would be especially ill-advised at a time when higher borrowing costs are already taking a toll on the housing sector, which was a particular beneficiary of the Fed’s mortgage bond buys.
Perhaps Fed officials could borrow a page from medicine and develop their own monetary version of the Hippocratic oath: First, do no harm.
This is an opinion column. The thoughts expressed are those of the author.