The Federal Reserve appears to believe that the size of its balance sheet matters, but not that bigger is better. The question is, why not?
As the Fed pushes ahead with plans to shrink its stock of about $2.5tn of Treasuries and $1.8tn of mortgage-backed securities to “normal”, it is puzzling that officials haven’t provided a compelling case for why the move is either necessary or desirable.
Various members of Fed’s policy-setting committee now say they want to slowly halt the reinvestment of principal capital from maturing bonds. The process could start as soon as later this year, according to the minutes from the Fed’s March meeting.
This comes when strong arguments for a permanently large Fed balance sheet have been offered in recent years by academics, strategists, and policymakers — including even Ben Bernanke, the former Fed chair who oversaw its expansion. They contend that the Fed could change the composition of the portfolio instead of the size, allowing it to minimise potential problems.
First, a large Fed balance sheet is an obviously useful mechanism for controlling short-term interest rates, keeping them within a corridor. The rate paid on bank reserves acts as a ceiling while the rate paid by the Fed’s reverse-repo facility maintains a floor.
Second, a large Fed balance sheet can be used to satisfy the persistent and strong private-sector demand for safe short-term securities. This view was presented at last year’s Jackson Hole conference by Harvard Business School’s Robin Greenwood, Sam Hanson and Jeremy Stein. When this demand isn’t met by government-backed securities, market participants historically have turned to the private sector for alternatives that had the illusion of similar, money-like safety.
Financial institutions performed this alchemy before the financial crisis, notably through the issuance of private mortgage-backed securities. And we all know how that ended. The Harvard academics propose that the government fill more of the demand for safety with greater issuance of short-term ultrasafe securities, which would be held on the Fed’s balance sheet. This would “crowd out” riskier competitors from the private sector, they say.
Third, shrinking the Fed’s balance sheet and draining US banks’ reserves would limit overseas banks’ ability to access dollar funding, in part thanks to bank leverage restrictions, as explained by Zoltan Poszar of Credit Suisse.
Fourth, a large balance sheet helps accomplish the goals pursued by other post-crisis reforms. Stricter regulation of money market funds and the implementation of higher capital and liquidity ratios diminish the gap between the perceived and actual safety of claims issued by the financial sector. Correspondingly, a large Fed balance sheet means that the provision of safe assets continues to reside with an institution that is the ultimate backstop for the financial system.
Finally, there is a limit to how much the balance sheet can shrink, as Mr Bernanke wrote in a blog post this year. Fed staffers estimate that US currency in circulation — the biggest liability on its balance sheet before QE — could grow to $2.5tn by 2025. And if Fed officials want to keep paying interest on bank reserves to control interest rates, that would require more reserves in the system than existed before the crisis. Mr Bernanke estimated that the current optimal size for the Fed’s balance sheet would be greater than $2.5tn, and could rise to $4tn in the next decade.
In fairness, Fed officials have urged caution. Boston Fed President Eric Rosengren said on Wednesday that officials should move slowly to avoid jolting markets, and should consider purchasing more securities in a downturn.
But Mr Rosengren’s argument assumes the desirability of shrinking the balance sheet in the first place — without articulating much of a reason. Neither have the rest of his colleagues.
One plausible explanation is that the Fed fears politicians will be spooked by the multi-trillion dollar balance, threatening to undermine the Fed’s independence. Fair enough, but that too is an argument for the Fed to be more forthcoming about its intent and aims, not less.
Monetary policy has evolved very quickly in the past decade. The arguments in favour of a big balance sheet are not foolproof, and it is possible that the Fed has reasons to discount them. That uncertainty is precisely why the Fed also must be more explicit about its reasons for moving ahead with its plans — or else abandon them altogether.