Comments on Exiting the Era of Big Balance Sheets

Balance sheets of central banks in advanced economies have ballooned by trillions of dollars since the onset of the Great Recession.  Now, U.S. policymakers are beginning to focus on the goal of unwinding the balance sheet.  While the arguments for doing so are not convincing, it seems inevitable at this point.  That said, there are several things that seem to missing from policymakers’ discussions this far of the unwind of which they must be very cognizant.

Firstly, it is important that policymakers communicate the balance sheet unwinding as a tightening measure in its own right.  That is, policymakers must make clear the distinction between unwinding the balance sheet and the future path of the federal funds rate.  This is in contrast to the so-called “taper tantrum” of the summer of 2013 when then-Chairman of the Federal Reserve, Ben Bernanke, spoke of the Fed soon “tapering” its bond purchases or when the Fed ultimately ended its bond purchases in 2014.  The taper tantrum caused significant global financial market volatility as traders priced in a higher expected path of the fed funds rate.  Similarly, when QE ended in 2014, fed funds rate expectations also began to grow, strengthening the dollar and tightening financial conditions globally (see figures below). This was despite the fact that the actual fed funds rate remained at the zero lower bound until December 2015.

fed-funds_expectations_

failed_US_forward_guidance
Fed Funds rate (orange), Fed Funds rate that was expected to prevail one (gray) and three (blue) years earlier.  Data for both images via Bloomberg.

Additionally, given the significant focus of QE on the safe asset market—i.e. U.S. Treasuries—there may be stimulative effects to the balance sheet wind-down, potentially undoing some of the negative impact of the safe asset shortage.  If the selloff can recreate term premia in Treasuries, there is less of an arbitrage opportunity in money/safe asset markets.  By reducing the incentive to “bet with” the central bank, investor resources will be reallocated toward the risk asset markets, and finance real, productive investment.  (Relatedly, it has been argued elsewhere that by releasing Treasuries and removing reserves, the Fed will increase the velocity of money market assets via rehypothecation.)

Similarly, if the Fed exits long-term assets while lowering or at least maintaining market expectations of short-term rates, the yield curve will steepen.  It is reasonable to assume that borrowers interest sensitivity is at or much closer to zero with interest rates at historically low levels.  Thus, there may be a boost in bank lending with a steepening of the yield curve—or, at the very least, a boost to bank equity which would also be stimulative.  This will have a stimulative effect in itself and increase broad measures of the money supply.  (A steepening of the yield curve may be the simple solution to President Trump’s “my friends can’t get loans” complaints.)

Lastly, there is concern that the Fed will not be able to make a smooth transition to a smaller balance sheet given the significant impact that its QE purchases had on global markets.  However, there should be sympathy for the Fed’s view that it will be a smooth transition.  Given the colossal mistake the Fed has made by continually talking down its own stimulus as temporary (for example, here, all the way back in 2011), market players have always attempted to price in its eventual removal.  While this greatly limited QE’s stimulative impact, it will make it easier for the Fed to exit this stimulus without too many bumps.

 

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