Fed Balance Sheet Stuck At $4.5 Trillion

The decision by the Fed was mainly covered by the press as the third rate hike since the financial crisis, but I contest the biggest story is the new stance to avoid shrinking the balance sheet in the medium-term. Heading into the meeting, I made a convoluted prediction in that I expected the Fed to say it was going to shrink the balance sheet, but not actually do it when the deadline came. The reason I thought this was because the hawkish writing was on the wall, but I still thought it was impossible to go through with it. The Fed can never shrink the balance sheet because that would cause treasury bond yields to soar. The government cannot afford to pay such a high interest rate on the debt given the high deficits it already has.

After the ECB stops its asset purchases, it plans to maintain the holdings forever. The balance sheet will shrink as a percentage of the economy as the economy grows. The European economy has been growing so slowly that the balance sheet size will be significant for a long time. This maintenance policy is what I think the Fed will do.

There are pitfalls to the maintenance strategy as well. Because the balance sheet never shrinks and increases during times of distress, it can come close to encompassing the whole economy if the economy doesn’t grow fast enough during expansionary periods. If you think about it in terms of the last cycle, the balance sheet went up over five-fold, yet the economy has not increased nearly that amount. If the balance sheet keeps increasing at that rate during times of crisis, it becomes a bigger problem after each crisis. One more point worth adding is that the Fed still is buying new bonds after old ones mature, rolling them over. If the economy was strong, the Fed would be able to let them expire. Even with rates up 75 basis points, the Fed still has crisis-era policies in place.

Now I will review the specific points Yellen made about the balance sheet. They don’t pass my logic test. At the post-FOMC news conference, Yellen stated "Our short-term interest rate target is our key active tool of policy." I find it interesting how when the crisis hit, the Fed had many tools in its tool chest, but now when it comes to putting the tools away, the Fed only puts some of them away. An analogy to this is a child playing with his toys. The parent tells the child he needs to clean up his room because he can’t play with every single toy he has at once. The child takes one part of one toy and puts it away, claiming the task to clean up his room is done. The Fed still hasn’t normalized interest rates after eight years of the recovery and has done nothing to shrink the balance sheet. It has not cleaned up the mess it has made.

Another point Yellen made was the following: "We think it's much easier using that tool to communicate the stance of policy. We have much more experience with it and have a better idea of its impacts on the economy." It certainly is easier to provide guidance on interest rates than guidance on the balance sheet. This is because the rate hikes happen on the day of the announcement, while bond sales would likely occur over a period of time. They can’t sell all the bonds they plan to sell for the year on one day because it would flood the market. The Fed would also want to coordinate with the treasury so it doesn’t sell bonds on the same day as big offerings. The Fed would also have to determine whether to sell mortgage bonds or treasury bonds or both.

Saying the Fed knows the impact of rate hikes better than selling its bonds is disingenuous. The Fed knew what it was doing when it purchased the bonds and is now claiming ignorance on how to reverse the decision. I contest the Fed knows what the effect on the economy will be; it knows the economy won’t be able to handle it. Getting back to the analogy I came up with, the child is claiming he can’t put his toy away because he doesn’t know how to put it together even though he studied how to use it for weeks.

Fed chair Yellen stated that the Fed would be reluctant to use the balance sheet to try to stimulate or hold back the economy. This is ridiculous because the Fed used QE to get the economy back on track. It lowered interest rates and bought treasuries to lower bond yields so investors would put their money in riskier assets like stocks to create the wealth effect that higher equities bring. The Fed is saying it won’t use the balance sheet to influence the economy except when it feels it needs to. It will only feel it needs to when the economy is in crisis. Hence, it will only expand and never contract meaningfully.

Finally, Yellen made the following point: "What we'd want to have is confidence in the economy's trajectory, a sense that the economy will make progress, that we're not overly worried about downside risks with adverse shocks that could hurt the economy." The statement proves my earlier point that crisis-era policies are still in place because the economy can’t handle the Fed selling bonds. The Fed expects long-run GDP growth to be 1.8%. Since the economy has grown higher than that rate at times this recovery and the Fed didn’t wind down the balance sheet, I take that to mean it will never do so.

Conclusion

I think the Fed will never meaningfully sell its bonds. It can’t be honest about this policy because its afraid of the consequences markets will bring. If everyone knew the Fed would only buy bonds and never sell them, bond yields would fall and stock multiples would grow, thus inflating the bubble to epic proportions.

Spread the love

Comments are closed.