Back to normal
The Fed may find unwinding its balance sheet more challenging than it expects.
3 April 2017
The Fed finally appears ready to normalize monetary policy. Starting with the March Federal Open Market Committee meeting, the Fed is on track to do multiple interest rate hikes in 2017.
Soon after it should begin unwinding its balance sheet. This path to monetary policy normalization, though, may be fraught with surprises and setbacks. Not only must the Fed avoid getting ahead of the recovery with its interest rate hikes, but it must delicately navigate the shrinking of a balance sheet that has grown fourfold since 2008.
This latter task may prove to be especially daunting since it puts the Fed in unchartered waters. Never before has the Fed had to shrink its balance sheet. It is effectively flying blind and the stakes are high. The unwinding of the Fed’s balance, then, is the Fed’s next big challenge.
The history of the Fed’s large balance sheet begins in late 2008, when it could no longer lower its short-term interest rate target to support the recovery. The target rate reached zero percent, so the Fed began purchasing long-term treasury and mortgage-related securities in order to lower long-term interest rates. The Fed hoped it would stimulate the economy.
These transactions, however, did not pack much economic bang for the buck and therefore required large-scale asset purchases by the Fed. By the time the Fed was done in late 2014, it had expanded the size of its balance sheet from roughly $900 billion to $4.5 trillion. Since then, the Fed has kept the size of its balance sheet constant.
The large increase in the Fed’s holding of treasury and mortgage-related assets was matched by a large increase in its liabilities, the money created by the Fed. Prior to 2008, most of the Fed’s liabilities were currency and a small portion were bank reserves. That flipped after 2008 with most of the Fed liabilities being bank reserves.
To effectively manage this large increase in bank reserves, the Fed began paying banks to deposit their excess reserves at the Fed. This interest payment on excess reserves was safe and higher than what banks could earn on other short-term safe investments like treasury bills. Banks, consequently, began parking their funds at the Fed. These excess reserves, along with the Fed’s assets, kept growing through late 2014 and have remained elevated ever since.
The large size of the Fed’s balance, though, does have an expiration date. Since the large-scale asset purchases began, the Fed has been clear that it intends to shrink its balance sheet once it gets interest rates on a rising path again. Chair Janet Yellen reiterated this point last month before Congress, and recently St. Louis Fed President James Bullard began talking up the need to reduce the size of the Fed’s balance sheet. With several interest hikes likely in 2017, this could be the year the Fed begins unwinding its balance sheet.
Not everyone, however, is eager to see the Fed shrink its balance sheet. Some observers, like former Fed Chairman Ben Bernanke, want to keep the Fed’s balance sheet large because it provides a safe place for financial firms to deposit funds. In times of financial stress this would prevent panic, but it would also mean a creeping nationalization of finance. Financial firms would be depositing funds at the Fed rather than at other financial firms. Many find this troubling since they believe central bank intervention into private credit markets will distort financial intermediation.
Other observers, like economist David Andolfatto, want to keep the Fed’s balance sheet large because it is profitable. As noted above, the Fed manages its large balance sheet by paying banks to sit on their excess reserves while also earning interest on its holdings of longer-term treasury and mortgage-related securities. The difference between what it pays to banks and what it earns on its investments has averaged about $80 billion annually over the past seven years. Most of the earnings are sent to the U.S. government. This helps reduce government budget pressures, but it also means that if Fed ever lost money on its large balance sheet, the taxpayers would have to pay for it.
Moreover, even if the Fed continued to be profitable with a large balance sheet, rising interest rates would mean the Fed has to pay banks larger and larger interest payments. This is bad optics for the Fed. Paying the same banks that were bailed out bigger and bigger interest payments would be hard to explain to a public increasingly swayed by populist angst.
For the above reasons and the improving economy, the Fed is determined to shrink its balance sheet. Doing so, however, may be harder than Fed officials imagine for several reasons.
The first reason is that the Fed’s normalization plans involve some potentially disruptive steps. One is the Fed’s desire to raise its short-term interest rate target before shrinking its balance sheet. As economist Tim Duy notes, this sequence could cause short-term interest rate to rise faster than long-term interest rates, a flattening of the yield curve. This would cause problems for financial firms that depend on the spread between these interest rates for profitability.
Banks, for example, generally earn more on their long-term home and auto loans than on the interest payments they make to their short-term depositors. If, however, short-term interest rates were to rise above long-term interest rates they could start losing money. Lending would be cut back.
If, instead, the Fed began shrinking its balance sheet at the same time it was raising its interest rate target, both short-term and long-term interest rates would rise more closely together. This would occur because shrinking the Fed’s balance sheet would be releasing the Fed’s long-term securities to the public and that, in turn, would push down their prices and drive up their yields. This would better for financial firms and the economy.
Another problem with the Fed’s normalization plans is that it calls for a passive unwinding of the Fed’s balance sheet. In other words, the Fed would refrain from reinvesting payments it earns on its securities as they matured. This would automatically shrink the Fed’s balance sheet.
While some tout this feature as simple and predictable, it also would make the process bumpy. The reduction would not be a smooth process, but one with irregular and sometimes large declines in the Fed’s balance sheet as various securities matured. In 2017, for example, $164 billion of securities mature on the Fed’s balance sheet. That number jumps to $425 billion in 2018 and then back down to $352 billion in 2019. It would be better to actively manage the shrinking of the Fed’s balance sheet to keep it smooth.
The second reason the scaling back of the Fed’s balance sheet may be challenging is that post-2008 regulation now requires banks to hold more liquid assets. Specifically, banks now have to hold enough high-quality liquid assets to withstand 30 days of cash outflow. This liquidity coverage ratio has increased demand for such assets of which bank reserves and treasury securities are considered the safest. So, in theory, as the Fed shrank its balance sheet, the banks could simply swap their excess reserves (that the Fed was pulling out of circulation) for treasury bills (that the Fed was putting into circulation). The challenge, as observed by George Selgin, is that the Fed’s interest on excess reserves has been higher than the interest rate on treasury bills. This creates relatively higher demand for bank reserves.
Banks would not want to give up the higher-earning bank reserves at the very moment the Fed was trying to pull them out of circulation. This tension could create an effective shortage of bank reserves and be disruptive to financial markets. The solution here would be for the Fed to lower the interest on excess reserves to the level of treasury bill interest rates.
The above suggestions of simultaneously shrinking the Fed’s balance sheet while raising interest rates, actively managing the reduction of assets, and lowering the interest on excess reserves to the level of treasury bill yields would go a long way in making the decline of the Fed’s balance sheet less disruptive.
More generally, the Fed needs to tie its balance sheet policies to the state of the economy. It should explicitly commit to reducing its balance sheet a certain dollar amount each month as long as the economy continues to improve. These plans should be communicated clearly and regularly to the public. Tim Duy suggests one way to do this is to have the Fed start providing forecasts of its balance sheet in the quarterly Summary of Economic Projections.
Together, these steps should improve the Fed’s ability to handle its next big challenge, the unwinding of its balance sheet. Let’s hope the Fed gets it right.
