The Federal Reserve must have reasons it wants to shrink its balance sheet, but officials haven’t been terribly clear about them.
In fact, I wrote in the latest Weekend FT about some of the compelling arguments against reducing the size of its holdings, citing prominent academics (including Ben Bernanke!) who said it might make sense to change the balance sheet’s composition instead of its size. But rather than addressing those arguments publicly, officials have mostly just assumed it’s necessary:
As the Fed pushes ahead with plans to shrink its stock of about $2.5tn of Treasuries and $1.8tn of mortgage-backed securities to “normal”, it is puzzling that officials haven’t provided a compelling case for why the move is either necessary or desirable…
In fairness, Fed officials have urged caution. Boston Fed President Eric Rosengren said on Wednesday that officials should move slowly to avoid jolting markets, and should consider purchasing more securities in a downturn.
But Mr Rosengren’s argument assumes the desirability of shrinking the balance sheet in the first place — without articulating much of a reason. Neither have the rest of his colleagues.
More explanation from the Fed is needed — and it seems more explanation from me might be helpful, too. The best arguments against reducing the central bank’s Treasury holdings turn on details that the column didn’t have room for, and the explanation of that led to some interesting debates with readers and commenters.
So rather than boring you all with excessive sourcing, I’ve decided to present these debates as a fictionalised dialogue between an imaginary sceptical Alphaville reader and myself. If any real-life sceptical readers have questions or arguments, feel free to add them in the comments.
You say the Fed shouldn’t assume that it needs to shrink its balance sheet. This idea just makes me uncomfortable. Where’s the benefit in that?
Harvard professors Robin Greenwood, Sam Hanson and Jeremy Stein say a large Fed balance sheet could promote financial stability.
That’s because it could help fulfill some of the special demand for “financial claims that are safe, short-term, and liquid—i.e., claims that share many of the core attributes of traditional money”. And it would keep that demand from being directed into private-sector alternatives, which are less safe.
OK fine. Don’t we already have a lot of regulations that are supposed to reduce risk in the financial system? What about high-quality liquid asset requirements, leverage ratios, and all that stuff?
Good point! Post-crisis regulations adopted worldwide do already try to limit the amount of risk involved in bank activities. And if you’re opposed to prescriptive financial regulations, you might want to support a permanently large balance sheet instead of those rules. (Treating the symptom rather than the maturity-transformation disease, you could say.)
What happens if there’s another recession? Don’t officials want to free up space so they can buy bonds again if the economy tanks?
Erm, there isn’t really a physical or legal limit on how much “space” the Fed’s balance sheet can “take up”. Its holdings are just assets that correspond to bank-reserve liabilities. Dual-entry accounting is a heckuva technology, right?
OK smartass, you know what I meant.
Right, yes, there is probably some theoretical limit to balance-sheet growth, though it would change with the economic environment. Printing buckets o’ money to buy long-term securities is generally inflationary during an expansion, but it clearly didn’t have the same effect during the financial crisis.
So, let’s assume the Fed’s holdings have to stay below some (unknown) size, or else inflation will take off and investable securities will become scarce. The Fed could still buy long-term Treasuries or other securities in the next recession without growing its balance sheet.
Are you just saying they shouldn’t sell the securities? Officials already said they aren’t planning do that, they’ll just slowly stop reinvesting proceeds from maturing securities. Ugh, this is the worst take.
No, no, that’s not what I’m saying. Remember Operation Twist?
… Yes.
OK, so keep that in mind while we look at a proposal from HBS’s Greenwood, Hanson and Stein.
They say the Fed should get rid of its mortgage-backed securities and long-term Treasuries, and instead keep a large balance sheet invested in shorter-term Treasuries (maturing in two to five years, they say) or invested in securities issued by the Fed (possible, but might feel like a stretch for everyone involved). Boston Fed President Eric Rosengren also mentioned the possibility of changing the balance sheet’s composition to steepen the yield curve — in much broader strokes — in late 2016.
If the Fed invests its balance sheet in short-term government securities, why couldn’t officials ease policy during the next recession by re-twisting? If there’s a good reason it couldn’t use the same method to buy medium-to-long-term Treasuries, or securities in a different market, the Fed hasn’t mention it.
Right, it always seemed sketchy that the Fed was a big player in (nominally private) markets for mortgage-backed securities. Owning only Treasuries solves that problem, at least.
But let’s get back to the recession scenario. Wouldn’t selling short-term Treasuries in a recession put stress on the market?
Well, let’s not forget that officials have pledged that rates would remain their primary tool for policy. So you’d assume the Fed would cut short-term rates well before it sold its holdings. That could keep the yield curve from getting too weird.
And when it comes to actual market mechanics, the large balance sheet has proven itself very useful for controlling short-term interest rates, as Bernanke pointed out in a blogpost last year.
What about the economic argument? Wouldn’t it be overly stimulative for the Fed to keep its balance sheet large?
Most studies about the effectiveness of QE have focussed on the effects of long-term security purchases, and it’s not clear that the Fed’s ownership of short-term securities would have the same stimulative effect. (Though I’d be curious to see any studies if I’ve missed them, so do email them along to alex.scaggs@ft.com.)
Academics have published work showing that purchases of MBS reduced spreads on risky debt. They also found that purchases of longer-term Treasuries increased the premium investors were willing to pay for safe long-term investments.
Or, stated a different way, it suppressed the term premium, that confusing catch-all for the part of Treasury yields that can’t be explained by expectations for interest rates or inflation. So let’s say the point of Treasury-market QE was to boost demand and decrease the risk that unexpected factors would hurt Treasury prices over the long term. Wouldn’t it make sense to think that the Fed’s balance sheet wouldn’t have the same effect if it were invested in shorter-term stuff?
What about the collateral issue? Doesn’t the market need that stuff for use as safe collateral for secured short-term financing?
Another interesting question! Manmohan Singh says the balance-sheet shrinkage could actually count as easing, since it’d put more quality collateral into the market.
If you think that reuse of collateral is necessary to get money moving and stoke inflation, the Fed’s balance sheet shrinkage is a good thing. But if you think too much collateral reuse is dangerous, the opposite would be true.
At the moment, it doesn’t look like anyone’s at a loss for places to put cash. Money-market funds can use the Fed’s reverse repurchase facility if there’s a lack of liquidity in private markets, after all. But for bank clients like hedge funds who want to borrow cash, the private-sector options aren’t as robust as they were when banks could use as much leverage as they wanted.
However, the Fed was at one point trying to reduce the stigma of borrowing from the discount window and FX swap lines, which provide a public cash-borrowing alternative for public and private banks. (Hedge funds would still be out of luck in that scenario, though. No discount-window access.)
That brings us back to the central question of the Fed’s balance sheet: What role should the government play in markets?
Or: Should the Fed be a universal provider of short-term dollar liquidity; only a last-resort provider of dollar liquidity; or somewhere in between, which is what it is now?
The Fed currently borrows cash from (and pays interest to) primary dealers, foreign banks and money-market funds through the RRP facility. For banks, it pays interest on excess reserves and allows access to the discount window, where they can borrow cash in a pinch. For foreign banks experiencing dollar surge pricing, it allows access to its FX swap lines.
These programs are complex and patchwork — so while dollar liquidity is provided by the Fed, it’s provided as part of a public-private partnership, with details that are so complicated that it’s difficult to discern that fact without lots of research.
In a way, the Fed is using an exceptionally American method of providing public services: Provide a public good, don’t tell anyone that it’s coming from the government, and pay a bit extra to the people who do a nice job helping you keep up your ultra-free-marketeer appearance.
Speaking of governments, what would a large balance sheet mean for the Treasury Department? Oh, and what about all the personnel changes coming up at the Fed?
This is where things get even trickier. And it’s why, at the end of the day, it might not be a great idea for the Fed to keep a perpetually large balance sheet.
Thanks to a 2011 accounting rule change, the Fed won’t show a negative capital position if it loses money on its portfolio, which is good news. But Congress could get used to relying on money from Fed remittances to fund projects. If that happens, and paper losses prevent or delay remittances from going through, the Fed’s independence could be at risk.
We should note that we’ve already seen steps towards that fiscal-conservative nightmare scenario, where taxpayers run off with the monetary printing presses. (During a Republican Congress, no less.) In late 2015, Congress decided it would use $19.3bn of the Fed’s surplus — basically, future Treasury remittances — to pay for a highway bill. That was money the Fed already had, of course. The biggest danger surfaces if Congress gets a little too comfortable and starts counting on future Fed payouts.
[Updated: Commenter Obruni points out that last year’s House budget banned the use of Federal Reserve surpluses as an offset. That is a good thing! But it’s conceivable that they could eventually un-ban the practice, since it was just part of the budget. In contrast, the 2015 highway bill actually amended the Federal Reserve Act, in order to cap the Fed’s surplus at $10bn.]
It’s also somewhat worrying that the Fed will have lots of turnover in coming years (including Chair Janet Yellen and Vice Chair Stanley Fischer in 2018). If brand-new members perceive a mandate to get creative with the balance sheet, they could push the envelope too far and breach that limit mentioned at the top of the story and risk stoking inflation or securities scarcity.
So, yeah! The political environment seems like a legitimate risk, and a convincing case for not experimenting with the Fed’s balance sheet.
But officials should come out and talk about those risks, and have a real dialogue about just how involved the public wants them to be in markets. Otherwise, officials could give the impression they’re a group of academics supporting the economic status quo — and recent political dialogue hasn’t been terribly kind to that group.
Related links:
Why shrinking the balance sheet might have an easing effect — FT Alphaville
The Fed must be clearer on its balance-sheet plan — Financial Times
Where would you prefer your balance sheet — banks, or the Federal Reserve? — FT Alphaville
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