Fed Shouldn’t Mess Around With Its Balance Sheet Wind-Down
(Bloomberg Opinion) -- If the Federal Reserve’s goal was to calm markets after a tumultuous end to 2018, it has largely succeeded. U.S. stocks have staged an impressive comeback from their lows, the high-yield bond market just had its busiest week since August, and even leveraged loans are rebounding. All it seemed to take was Chairman Jerome Powell and other officials saying that the central bank’s plans to reduce the size of its balance sheet wasn’t quite on autopilot after all.
Yet there’s some indication that policy makers want to take it a step further. The Wall Street Journal reported Friday that officials are considering a quicker end to the runoff, and that Powell might hint at a change in plans at a press conference following the Federal Open Market Committee’s meeting next week:
Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.
Officials are still resolving details of their strategy and how to communicate it to the public.
This is mostly extrapolating from recent public comments and interviews. Still, communicating anything beyond what’s already been said about the $4 trillion balance sheet would be a mistake for Powell. He already shifted his tone earlier this month, saying policy makers “wouldn’t hesitate to make a change” if necessary on the pace of the wind-down, a sharp pivot from his previous stance that it would effectively be on “automatic pilot.” That change was soothing enough for markets, while also preserving a significant amount of flexibility for officials to react to incoming economic data and financial conditions.
What’s been clear from the start is that if Powell had his way, there would be virtually no talk of the balance sheet, or presidential tweets about “the 50 B’s.” His view is that the fed funds rate is the central bank’s primary monetary policy tool. He was backed into a corner, however, because markets honed in on the balance-sheet runoff as (presumably) a potential risk to liquidity and reserves in the banking system. Either that, or investors simplistically referred to it as “quantitative tightening” and assumed they should do the opposite of what did they during the QE era — namely, shed risk instead of adding it.
Maybe investors don’t understand that the Fed has very modest goals when it comes to its balance sheet. No one expects it to return anywhere close to pre-crisis levels. Indeed, as the Journal’s article notes, previous estimates were for the portfolio to shrink to somewhere between $1.5 trillion and $3 trillion, with many officials leaning toward the upper end of that range. That means policy makers are well on their way. Powell had said in November 2017 that the runoff would likely last “three or four years.”
To be fair, there might be technical reasons that policy makers think the balance-sheet unwind deserves a second look. BMO Capital Markets strategist Jon Hill noted that daily volume in the fed funds market fell below $50 billion this week for the first time since early 2016. The effective fed funds rate is trading right in line with the Fed’s interest rate on excess reserves, which is an unusual phenomenon and could signal some strains on liquidity. Basically, if the central bank does tweak its policy, it’s not going to be because of its view on the economy.
Nuance is easily lost on markets when it comes to Fed policy, however. That means the headline “Fed Officials Weigh Earlier-Than-Expected End to Bond Portfolio Runoff” is going to color traders’ thinking before and after the FOMC decision on Jan. 30. The risk is that if Powell simply reiterates his past stance — that he and other officials wouldn’t hesitate to alter their pace if necessary — it would be interpreted as hawkish relative to the idea that he’d give a more concrete end date. There is almost no chance he boxes himself in like that.
All this serves to make the upcoming Fed meeting a lot more dramatic than it should be. In reality, it’s not that complicated. Policy makers are taking a break from raising interest rates, probably at least for the first half of this year, barring some spectacular rebound in economic data. The balance-sheet runoff will continue as planned, barring some significant decline in economic data.
Bond traders understand this, for the most part, which explains why the 10-year Treasury yield has fluctuated in a narrow 14-basis-point range since Jan. 8. It’s time for investors in riskier assets to get with the program, too.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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