Shrinking Balance Sheet

The size of the Fed’s balance sheet is becoming more of a focus than its decision on interest rates. This is because of increased Fed statements on the topic which I will go over in this article. Goldman Sachs is forecasting no changes to the balance sheet until mid-2018. This would be after the new Fed chairperson is appointed which makes answering the question of what policy it will pursue much tougher than it would ordinarily be. It’s tough because we don’t know who the appointment will be and what the FOMC will look like.

I said in a previous article that the Fed won’t shrink its balance sheet, but that forecast is contingent on the current people remaining there. If Trump picked a Fed chairperson whose explicit goal is to lower the Fed’s balance sheet, then obviously, that’s what is going to happen. There’s a reasonable chance that’s what Trump intends to do, so it’s something worth focusing on to determine the potential ramifications of such action. Some are saying the current Fed will get the ball rolling as a parting decision. However, this doesn’t matter in my opinion because it would be the equivalent of quibbling over which appetizer to eat before going to an all you can eat buffet. If there’s a political motive to shrink the balance sheet regardless of the effects on various markets, then it will be done. The future Fed won’t care if the maturity date of bonds was shortened. It will start selling the bonds instead of deciding not to roll them over.

This brings us back to forecasting what the current Fed has plans to do. While the Trump-appointed Fed could make these policies irrelevant, it’s still important to focus on them since they will be happening first. Saying this year’s monetary policies don’t matter is like saying Howard Schultz’s successful tenure at Starbucks didn’t matter because the next CEO could ruin the progress made. The market won’t stop pricing in what it thinks the current Fed will do until it becomes close to a sure thing that Trump plans to deviate from historical precedent. Maybe the market should start expecting big variations from the Fed, but it doesn’t seem to be doing so. I think sometime in September, the market will focus more on who he will choose.

The chart below shows the recent comments the Fed has made on the balance sheet. The volume of comments is notable. The reason I don’t think the Fed will be able to sell the bonds or let them mature without rolling them over is because a recession will likely come before it happens. The Fed operates under the assumption that recessions have been outlawed which goes against objective evidence. The potential for a recession is the reason why raising rates and unwinding the balance sheet so slowly is a problem. We don’t see that problem until the recession happens.

The statements made below are cautious ones proclaiming the possibility sometime after the Fed raises rates a couple more times, it will start the unwind process by letting some bonds expire without buying new ones. You can now see where my contention with the unwind process occurring is. I don’t think the Fed will be able to raise rates again. If it can’t go through what it called step one, then it won’t be able to get to the second step.

fedstatements

The next part we have to discuss is what will happen if the balance sheet is unwound. This would happen if either the current Fed sticks to its promises and there is no recession in the next 2 years or because the Trump-Fed unwinds it for political reasons. The effects of an unwound balance sheet will be impacted by the type of forward guidance given and whether they act in coordination with rate hikes or separately.

If the current Fed is maintained or similarly constructed and the economy remains in a similar position for the next 2-3 years, then I expect the Fed to explain what it will do beforehand and not unwind the balance sheet while raising rates. They will want to raise rates a few more times and then start unwinding it. The goal of maintaining financial stability would be achieved, but if inflation were to increase while the Fed was unwinding its balance sheet, its ability to fight it with rate hikes would be limited.

The Trump-appointed Fed may not provide as much forecasting. I think it would sell bonds instead of just letting them mature because that process would take too long. Trump would be out of office before the balance sheet would be fully shrunk. It also may unwind the balance sheet independent of what it does with interest rates because of political motivation. This would cause volatility in the market because, for the first time since the crisis, there would be a free market.

The mortgage bonds would have to be soaked up by the private market which means rates would increase. Increasing rates would hurt the housing market. It would allow only people who can afford a house at normalized rates to buy one. This would further lower the home ownership rate. If the Fed simultaneously raised rates and sold treasury bonds, there would be a mass cascade of selling in bonds causing yields to spike. This would hurt stocks which would suddenly face tougher competition from bonds in terms of return on capital. Bringing back the free market would be a tough pill to swallow which is why I didn’t think it would happen after Trump was first inaugurated. His initial decisions make me increase the chances of this policy being put in place, but I wouldn’t bet on it happening.

Conclusion

            The Fed has been talking about shrinking the balance sheet lately. Last year the Fed talked about 4 rate hikes and it only delivered one, so I don’t expect anything to happen because of these talks. At face value, the discussions imply allowing some bonds to mature starting in 2018 or 2019. By delaying the process so long, it’s almost as if the Fed wants there to be another recession, so it doesn’t have to go through with it. If Trump appoints hawks to the Fed who believe in free market capitalism, then an unwind would happen quickly and the market would be thrown into chaos. Surely, Trump must know this, so there’s not a high probability that he will go through with such an action.

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