The Fed’s Unwinding

Joseph Gagnon at PIIE thinks that the unexpected development was a further reduction in the median view of FOMC participants about where the short-term interest rate will settle in the long run. The Fed apparently endorses the view that the slowdowns in the growth rates of productivity and the working-age population have persistently lowered both the economy's potential growth rate and the rate of return on investment. Shrinking the balance sheet will tighten financial conditions because it will increase the amount of long-term bonds in the market and thus push up their yields. Much of any increase is probably already priced into bond yields, given that this decision was telegraphed so clearly in advance. The 10-year Treasury yield rose only 2 basis points on September 20, but it has risen 58 basis points over the past 12 months, in part reflecting expectations of today's decision. The FOMC continues to project another federal funds rate hike in December. However, Chair Janet Yellen made it clear in her press conference that many participants in the committee are troubled by the decline of measures of core inflation earlier this year. If data over the next three months do not show some evidence of inflation returning toward its target of 2 percent, as the FOMC currently expects, rate hikes are likely to be postponed. Richard Clarida on Pimco Blog thinks there are intriguing clues from the dot plot, which shows the median FOMC participant is inclined to hike the fed funds rate by year-end 2017 and also has marked down her or his longer run dot to 2.75% (from 3% in the previous dot plot in June). Clarida argues that the FOMC dot plot now clearly indicates that many on this committee expect that the Fed may have to overshoot the longer run neutral rate. This reflects the fact that the Fed’s statement of economic projections (SEP) shows U.S. unemployment falling to 4.1% over the next two years, well below the unchanged estimate of NAIRU of 4.6% (the non-accelerating inflation rate of unemployment). To keep projected U.S. inflation at 2% – and according to the SEP, the Fed expects to see 2% inflation by 2019 – the Fed’s models, and several of the dots, indicate this would call for a tighter-than-neutral policy rate. Each dot in the plot tells a story – but the eventual outcome is not yet written. James Hamilton at Econbrowser thinks we may not have seen the end of balance sheet expansion. He created a mock-up of what the balance sheet would look like if the Fed reduced its holdings by the maximal amount at a smooth weekly rate and supposing that the Fed maintains the rate achieved by the end of 2018 through 2019 and the first three quarters of 2020. These projections assume the Fed will resume growing its balance sheet in 2020 -Q4, and never let total assets fall below $3 trillion. The reason the Fed may go back to growing its balance sheet within three years comes from thinking about the liability side of its balance sheet. The big bulge in assets has mainly been financed by extra Federal Reserve deposits held by financial institutions, but several other liabilities are also significant– deposits held by the U.S. Treasury’s account with the Fed, deposits that get returned temporarily to the Fed through reverse repos, and currency held by the public. Source - Econbrowser A key feature of those last three is that under current Fed operating procedures these quantities are basically chosen outside the Fed. The reason that total liabilities have remained almost constant week-to-week for three years in the face of this volatility is that Fed deposits of financial institutions have acted as a big buffer, elastically growing or contracting in response to whatever happens at the Treasury or with reverse repos. In Hamilton’s simulation, if the Fed were to continue reducing its balance sheet through the end of 2020, the level of Fed deposits by financial institutions may not be enough to cover the plausible variation in other Fed liabilities. There are other changes the Fed may consider to its basic operating system, such as changing the way it conducts reverse repos, using temporary open-market operations to add or withdraw reserves as needed to offset changes in the Treasury balance, or moving to a true corridor system for controlling interest rates. The gradual pace of contracting the balance sheet gives the Fed a couple of years to sort out how it’s going to do that. The Economist’s Free Exchange makes the case against shrinking the Fed’s balance sheet. A way of viewing QE is as an operation that changes the maturity profile of government debt. The best size for the Fed’s balance-sheet therefore depends on the best maturity profile for government debt, once the liabilities of the Fed and the Treasury have been combined. If money is more useful than Treasury bills, then the Fed performs a useful service by swapping one for the other. And there is literature showing that money is useful, in the sense that abundant bank reserves increase financial stability, because otherwise increased money demand i satisfied by the private sector with very short-term debt like asset-backed commercial paper.