Fed official eyes balance sheet as inflation rises

The Federal Reserve should be ready to consider reducing the size of its balance sheet as part of its efforts to prevent overheating in the US, a senior policymaker said as he noted the pick-up in wage inflation and predicted a return of inflation to target by the end of the year.

Eric Rosengren, the president of the Federal Reserve Bank of Boston, said that if the Fed is in a position to lift rates with “more alacrity” than the one-a-year pace of rate rises seen in the past two years, then officials should be willing to debate reductions in the size of its huge asset portfolio.

If the central bank continues only lifting rates at a speed of 25 basis points a year, there was “no rush” to worry about the balance sheet, he added. 

“We should be considering it now, and at what point the committee actually decides to take action we will have to see,” he said in a telephone interview with the Financial Times. “But my own criteria would be if we think the economy is strong enough that we are going to need to do multiple tightenings . . . at that time we should be seriously thinking about reducing the balance sheet.”

The Fed amassed a $4tn stockpile of securities in its efforts to fight the financial crisis and economic slump, and the question of how to unwind that bloated balance sheet continues to hang over its strategy for normalising policy. With policymakers projecting a median three rate increases this year, following just one in each of 2015 and 2016, the issue will loom larger if the recovery remains on track. 

We should be considering it now, and at what point the committee actually decides to take action we will have to see

Janet Yellen, the Fed chair, reiterated in December as she discussed the central bank’s quarter-point increase in interest rates that policymakers would begin to allow its portfolio to run off once the process of lifting rates was well under way, stressing that there were no decisions on when this would occur. The process of allowing the balance sheet to run off would take “several years,” she added. 

Mr Rosengren argued that reductions should only begin if the Federal Open Market Committee was confident that the process was unlikely to be reversed, reaffirming that the change should be executed by reducing the reinvestments of maturing securities. 

Among the benefits of using the bond portfolio to help steer the economy is that changes to longer-term rates may have less of an impact on the exchange rate than short-term rates, he argued. They could also do more to shape investment decisions, he said, for example in commercial real estate.

Mr Rosengren has for some time been voicing concerns that gains in commercial real estate could go too far as a result of the easy-money environment in the US. 

The Boston Fed chief was speaking after a speech in Hartford, Connecticut, in which he noted “remarkable progress” in the US economy and employment and inflation approaching the Fed’s official mandate. 

He told the FT that he was concerned that the US could significantly overshoot estimates of maximum employment — something that could force Fed rate-setters to respond more sharply to keep the economy cool.

While inflation remains below target, “once it picks up it can be fairly difficult to slow down,” he said. He added that “significant” increases in wages could feed through into prices and that business leaders he spoke to were complaining about labour shortages. 

One of the key uncertainties hanging over the Fed this year is the possible shape of Republican-led reforms to lower taxes and potentially invest more in infrastructure. Markets have already been factoring in a looser fiscal policy, which could boost the economy and inflation. 

Mr Rosengren said he did not need “certainty” on fiscal policy to be willing to move rates again, and added that there would be more information on the likely shape of the budget plans well before midyear. 

“If we became even more confident that inflation was going to be at 2 per cent by the end of the year and it looked like the economy was already strong enough that we were likely to surpass full employment, and potentially by more than what we were expecting, that would be sufficient grounds for me to consider moving more quickly,” he said.

If fiscal policy ended up being less accommodative and the rest of the world was weaker than hoped, on the other hand, he would be willing to see less tightening.