The CEO and President of the St. Louis Regional Federal Reserve Bank, James Bullard, recently offered a presentation (here) making a case for reducing the size of the Fed’s balance sheet—at about $4.5 trillion as a result of the Fed’s crisis response (as opposed to less than $1 trillion pre-crisis). Bullard made several excellent points but I wanted to highlight and/or push back against a few.
First, Bullard rightly notes that the new presidential administrations fiscal spending plans (if actualized in the near term) are not countercyclical, and thus, market players may be overvaluing them as they price in inflation and growth (see Figure 1, from Bullard’s presentation). However, there may be some flexibility here if the headline unemployment rate is not telling the whole story of labor market slack. That is, even without a boost to productivity growth, there is a strong possibility that the U.S. output is not currently at its potential.
Additionally, there would be some effect of the fiscal stimulus to the extent that it brings forward the Fed’s 2% core inflation target. If the fiscal stimulus is enacted and has effects prior to reaching that target, it may raise the path of the price level, leading to higher nominal GDP levels and thus a stronger economy. Lastly on this point, Bullard’s warning that a fiscal stimulus would not be stimulative if the economy is at full employment shows that even he (a relative dove on the FOMC) is not considering a symmetric inflation target or nominal GDP level-targeting which is unfortunate for the US as we consider legacy debts and the Fed’s ability to respond to future crises; this leaves a lot of uncertainty on the table for individuals and promises to keep post-crisis jumps in risk aversion high.
Later in the presentation (see Figure 2), Bullard criticized a recent commentary by former Fed Chairman Ben Bernanke in which he relayed some agnosticism about the balance sheet and suggested holding fire on unwinding it.
While Bullard’s right that the signaling effect of a large balance sheet is a crucial transmission mechanism of its size, there are some clear reductions in long-term rates as a result of the policy (for example, see Gagnon et. al. 2011). Thus, continuing to use long-term rates to accommodate the economy may be preferable to short rates from a financial stability perspective as the Fed prevents some of the risk surrounding maturity-transformation from the market—financial stability, of course, being a common concern/critique from those wanting the Fed to unwind what they perceive to be excessive monetary accommodation.
[To be sure, excess maturity transformation doesn’t appear to present as it was leading up to 2008 crisis. Now, an argument could be made that there is actually insufficient maturity transformation taking place as broad monetary aggregates remain significantly below pre-crisis trends. Additionally, an elimination of the term premium also further enables the safe asset shortage problem. However, Bullard doesn’t seem to highlight these points when advocating for reducing the Fed’s downward pressure on the long end of the yield curve.]
Too, Bullard seems critical of the idea that the balance sheet would need to remain at a size of $4.5 trillion, but I’m not sure why. Not only could a recession very realistically happen before the balance sheet is wound down to the ideal long-term size, leaving the Fed to walk back on its “normalization” efforts, but there’s also been a jump in trend demand for currency since 2008 (Figure 3) as well as for reserves (as was later noted by Fed Governor Brainard) as post-crisis regulations have required more safe/liquid assets of financial institutions (among other reasons). As Governor Brainard noted, this implies a shift in the reserve demand curve that will require a higher level of reserves to maintain any given short-term rate.
Lastly, I want to push back on Bullard’s comments on the “policy space” debate. Many policymakers have made it clear that they want to wait until short-term rates have been hiked sufficiently far away from the effective lower bound before unwinding the balance sheet. This, they argue will allow them sufficient policy space—AKA room to cut rates—in the event that downside economic risks materialize and the Fed has to ease monetary policy again. Very sensibly, Bullard essentially says, same difference: policy space is policy space whether its via short rates or the balance sheet (Figure 4).
However, from a political viewpoint, I think it’s sensible for policymakers to not view all stimulus as created equal (as I’ve argued before). Especially in an era of Audit/End the Fed, cutting the short rate will require much less political capital—and will draw less political pushback—than another round of asset purchases. It’s much easier for politicians and the public to grasp a rate-cut as a market-friendly move, as opposed to asset purchases which are much more easily viewed as “distortionary.”