The Federal Reserve risks political interference and losing its independence if it maintains a large balance sheet in the longer term, former Fed officials have claimed, as debate over the central bank’s strategy for unwinding its interventions in financial markets intensifies.
Kevin Warsh, a visiting fellow at the Hoover Institution at Stanford University and former Fed governor, said permanently holding vast quantities of assets like treasuries was “fiscal policy in disguise” and risked turning the central bank into a general purpose agency of the government.
“A large balance sheet is a dangerous temptation for the rest of the political class,” he said in an interview at a conference at Stanford on Friday.
Charles Plosser, former president of the Philadelphia Fed, said that politicians might, as an example, push the Fed to purchase infrastructure bonds to help fund public works and argue they were not interfering with monetary policy. “They will see that balance sheet as a great opportunity to fund their spending without raising taxes,” Mr Plosser said.
The Fed’s policy of purchasing government securities and mortgage-backed securities during the crisis has long raised worries about whether its independence could be impaired if the boundary between monetary and fiscal policy gets blurred. The debate has been rekindled as Fed policymakers discuss how far to pare back their holdings of securities and the appropriate mechanisms for setting rates in the longer term.
While policymakers want to shrink a balance sheet that swelled to $4.5tn during quantitative easing, many believe asset holdings will need to remain much larger than before the crisis. They are also preparing the markets for the possibility that they will have to undertake new rounds of purchases in future to battle recessions.
Many conservatives were highly critical of the Fed’s ultra-easy monetary policies, and their views are front and centre now that Republicans control the White House and Congress. John Taylor, a senior fellow at the Hoover Institution, said in an interview that the Fed should move back to its old way of steering rates by varying a scarce supply of reserves. “There is some value to having a system where you don’t normally have large-scale asset purposes or quantitative easing or purchasing mortgages,” said Mr Taylor, who served under both George Bush senior and junior.
Against that view, other economists predict the balance sheet will need to stay at $3tn or more as commercial banks’ reserves at the Fed remain far above pre-crisis levels. These reserves would contribute to the supply of safe assets held by banks and keep the Fed’s post-crisis interest rate-setting mechanism in place. The latter involves the Fed paying interest on excess reserves alongside a reverse repurchase facility to set rates among other financial firms. Ben Bernanke, the former Fed chair, has suggested it may be necessary to have at least $1tn of reserves.
Eric Rosengren, the Boston Fed president, said at the Stanford conference that the political-economy questions surrounding Fed interventions in asset markets remained a concern. But he also insisted that the Fed was likely to undertake asset purchases in future downturns. This was because the fed funds rate may only be lifted to 3 per cent in the longer term, limiting the central bank’s conventional recession-fighting firepower. “It is inevitable that we will be talking about the balance sheet in future recessions — and in fact in most recessions unless they are very, very mild,” he said.
Charlie Evans, the Chicago Fed president, told the conference that the balance sheet would not shrink back to its modest, pre-crisis size given subsequent growth in the economy and currency, but that maintaining a large balance sheet “does open you up to political interests weighing in perhaps”.
Mr Warsh, who like Mr Taylor is mentioned as a potential candidate for Fed chair under President Donald Trump, said he was in favour of an “aggressive, powerful” central bank intervening when a major shock hits as during the financial crisis, but also of a “more traditional central bank when the shock does not hit”.
He was highly critical of the Fed’s current approach to the balance sheet. “They have announced they are going to be exiting in all likelihood, but they haven’t announced principles; they haven’t announced how; they haven’t announced why; they haven’t announced the objective,” he said. “I don’t really understand the sequence of that; we are exiting and then we’ll tell you later why we are doing it.”
Fed policymakers have stepped up their public discussions of balance sheet strategy in recent months, and in the minutes to its March meeting the Fed said that if the economy stays on track the central bank could initiate a reduction of the balance sheet later this year. Firm data for the second quarter including a buoyant jobs report on Friday have made a further increase in short-term rates likely next month.
