How the Fed's balance sheet adds to its policy toolkit
The Federal Reserve (Fed) will seek to gradually remove its accommodative policies, not tighten to the point it slows growth. At least not yet. An expanded toolkit should help it find the right balance.
Unstructured Learning Time
The post-Financial Crisis period is “out of sample” compared to the experience of investors over the last 40 years.
The behaviour of the Federal Reserve (Fed) is one of the most obvious illustrations of this. Namely, the unprecedented low rates and open market purchases of bonds it has presided over. The other obvious factor is the persistent low level of growth that has failed to ignite either consumption or capex animal spirits.
Many factors contribute to the current situation, including high levels of debt, a maturing demographic less willing to spend, and increased regulation which makes everyday business more difficult.
Fed focus on balance sheet
Now, there is now a further twist in the tale. In the recently-released minutes of the March 14-15 Federal Open Markets Committee (FOMC), Fed officials referenced the need to address the large Fed balance sheet that resulted from quantitative easing policy earlier this decade. (See also our recent article “Fed hiking cycle may spark unusual bond market reaction”)
This sentiment was affirmed more forcefully by New York Fed president Bill Dudley. He suggested a pause in Fed rate increases followed by an end/reduction in balance sheet cashflow reinvestment, which would allow the asset level to passively decline. This is a new policy tool.
Investors in recent years have become familiar with the Fed’s adjustments of short-term interest rates – implemented through its open market operations – to manage economic activity. There have been other means by which the Fed could affect activity, including the altering of margin levels and bank reserve requirements. For example, the Fed effectively eased monetary policy by using its balance sheet to purchase Treasury and mortgage securities after 2008. This is because it removed bonds from the market, which allowed long-term interest rates to fall (lowering borrowing costs) and also flooded the market with liquidity, which drove up other asset prices.
Trio of tools
By using its large balance sheet, the Fed now has three tools to implement monetary policy. It can use the traditional Fed funds rate, which affects short-term lending rates. It can also dispose of longer-term securities from its balance sheet to impact long-term interest rates. Finally, it can alter the money supply in the economy through its “reverse-repo” policy
This now creates an unprecedented level of uncertainty about how monetary policy will unfold in the future. As indicated by the FOMC minutes and Dudley’s comments, we should expect a shift from higher short-term rates in favour of balance sheet decreases sometime toward the end of 2017.
Forecasting Fed policy has been difficult even in the best of times. And even the Fed itself has not been effective at changing policy to meet its own forecasts. However, we can look at the intended impact of each of the major policy tools to create a roadmap for future Fed policy.
The second two policy tools effectively allow the Fed to disentangle the duration and cash impacts of balance sheet sales.
The Fed understands that this recovery cycle has been unique and may still be fragile, so is likely to proceed with caution unless there are significant changes to fiscal or regulatory policies. However, it is aware that easy monetary conditions will eventually lead to excesses.
So, we’re reminded that the Fed is most interested in gradually removing the policy accommodation put in place over the last nine years. Not in tightening to the point it slows growth. Not yet anyway.
Finding that equilibrium will be difficult for the Fed and its expanded toolkit should aid it in adjusting policy to economic conditions. This roadmap should help investors anticipate future policy changes.