One of the more controversial topics to emerge over the past three weeks has been the "trial balloon" by various Fed presidents, most notably Bullard and Harker, suggesting that the time to start unwinding the Fed's balance sheet is almost here. While much of the sellside has quickly piggybacked with their own analysis, many suggesting that such an action would not impact most asset classes (except for MBS), an assumption we frankly find ludicrous as the main reason for the current level on the S&P is precisely the $14 trillion in global central bank liquidity injections...
... so far there has not been an official statement by Janet Yellen, or any members of her closest circle. So in lieu of that, we will resort to the next best thing - the opinion of the man who inflated the world's biggest central bank balance sheet bubble himself, Ben Bernanke, who addresses this topic in a note on his Brookings blog titled "Shrinking the Fed’s balance sheet"
Cutting to the chase, Bernanke is not at all impressed with that particular proposed normalization, to wit:
The FOMC has been clear that its current tightening campaign would ultimately involve shrinking the central bank’s balance sheet, but it has also said that will not begin that process until “normalization of the level of the federal funds rate is well under way .” In short: rate increases first, balance sheet reduction later. However, recently, a number of Fed officials have begun talking about plans for shrinking the balance sheet, leading market participants and other observers to speculate that first steps in that direction may take place sooner than expected
Has the Fed’s approach to balance sheet normalization actually changed? At least until I hear otherwise from the FOMC’s leadership or the Committee as a whole, my guess (and hope) is that it hasn’t. As I’ll discuss in this post, the case for deferring action on the balance sheet until short-term rates are meaningfully higher remains at least as strong as it was when the FOMC’s strategy was first devised.
Bernanke says that while he has no position on the "appropriate pace" of monetary tightening, he is arguing that "whatever pace of tightening the FOMC chooses, it’s best implemented in the near term by increasing the short-term interest rate. Although some shrinkage of the balance sheet will likely occur at some point, there’s no need to rush that process."
He then makes the following two points against commencing a balance sheet unwind.
First, policy communication will be made easier and the risk of market disruption minimized if the shrinkage of the balance sheet, once it begins, is passive and predictable. In particular, once the runoff of the Fed’s assets begins, the FOMC should proceed on the assumption that it will not be halted. But since the effect of balance sheet reduction on broader financial conditions is uncertain, it is prudent not to begin that process until short-term interest rates are comfortably away from their effective lower bound, leaving the Committee room to offset any unanticipated effects.
Second, before beginning to shrink the balance sheet, the FOMC should have a clearer idea of what its ultimate size should be. As I’ll explain, under reasonable scenarios only a moderate amount of balance sheet reduction may ultimately be needed, reducing any urgency to begin the unwinding process.
Incidentally, that is a point which DB made two weeks ago, suggesting that due to the recent pick up of outstanding currency in circulation, the actual reduction in assets may not have to be that great after all (see chart above). This is what DB's Dominic Konstam said in mid-January.
The Fed balance sheet unwind took the headline this week. In the context of our QE-bond supply model, an abrupt end of SOMA reinvestments is worth 25 bps in higher 10yr yields by the end of 2017. If the Fed were to sell securities to speed up its balance sheet reduction, a pace of say $50 billion per month could push yields higher by an additional 35 bps. There are a couple of considerations. The most crucial one is that the Fed actually may not be able to sell any of its Treasury securities outright. The reason being that currency in circulation – a liability of the Fed for which it needs to pledge one-for- one with Treasury security collateral – has grown from $800 billion in 2008 to $1.5 trillion today. This leaves just around $1 trillion of “excess” Treasury securities in the SOMA portfolio. If the Fed lets these securities mature naturally without reinvesting, the level of holdings would run down to the minimum required level by 2019. Then the Fed may need to restart repurchasing Treasuries to adjust to the level of currency in circulation.
It appears that Bernanke read this analysis because he makes precisely the same point in his discussion of how big the balance sheet should be.
For reasons of transparency and predictability, when the FOMC announces the end of reinvestment it should also provide guidance about the ultimate size and composition of the balance sheet. That discussion appears still to be ongoing inside the Committee. As I noted here, there are reasonable arguments for keeping the Fed’s balance sheet large indefinitely, including improving the transmission of monetary policy to money markets, increasing the supply of safe short-term assets available to market participants, and improving the central bank’s ability to provide liquidity during a crisis. However, even if none of these arguments gains adherents on the FOMC, growing holdings of currency and changes in the Fed’s methods of implementing monetary policy alone may imply that only moderate reductions in the balance sheet will ultimately be required—another reason that it’s unnecessary to move quickly.
The growth in the public’s demand for currency is one (completely uncontroversial) reason that the Fed will need a larger balance sheet indefinitely. The minimalist central bank balance sheet, consistent with providing the public’s desired holdings of currency and nothing else, would include currency as the primary liability and government-issued securities as the primary asset. That’s a pretty good description of the Fed’s balance sheet before the crisis: liabilities were about $800 billion in currency in circulation, and assets (almost all in Treasuries) were only slightly greater than that. However, today currency in circulation has grown to $1.5 trillion. Because of rising nominal GDP, low interest rates, increased foreign demand for dollars and other factors, Fed staff estimates that, the amount of currency in circulation will grow to $2.5 trillion or more over the next decade. In short, growth in the public’s demand for currency alone implies that the Fed will need a much larger balance sheet (in nominal terms) than it did before the crisis.
He then discusses the right level of bank reserves, ostensibly the primary driver behind the asset, if not economic, reflation trade of the past 8 years:
What level of bank reserves would be needed for the Fed to continue to implement monetary policy by current methods? To ensure that the floor rate set by the central bank is always effective, the banking system must be saturated with reserves (that is, in the absence of the interest rate set and paid by the central bank, the market-determined return to reserves would be zero). In December 2008, when the federal funds rate first fell to zero and the Fed began to use the interest rate on bank reserves as a tool of monetary policy, bank reserves were about $800 billion. Taking into account growth in nominal GDP and bank liabilities, the critical level of bank reserves needed to implement monetary policy through a floor system seems likely to be well over $1 trillion today, and growing. Taking currency demand into account as well, it’s not unreasonable to argue that the optimal size of the Fed’s balance is currently greater than $2.5 trillion and may reach $4 trillion or more over the next decade. In a sense, the U.S. economy is “growing into” the Fed’s $4.5 trillion balance sheet, reducing the need for rapid shrinkage over the next few years.
After all that it is clear that Bernanke is not at all interested in beginning a balance sheet reduction, as he makes abundantly clear in his conclusion:
At some point the Fed is likely to reduce the size of its balance sheet. Without taking a position on the overall pace of monetary tightening, I’ve offered two arguments why beginning that process is not urgent. First, to minimize the risk that unwinding the balance sheet will disrupt markets and the economy, the best approach is to allow a passive runoff of maturing assets, without attempting to vary the pace of rundown for policy purposes. However, even with such a cautious approach, the effects of initiating a reduction in the Fed’s balance sheet are uncertain. Accordingly, it would be prudent not to initiate that process until the short-term interest rate is safely away from the effective lower bound.
Second, to allow for appropriate guidance to the public and to markets, it would be wise for the FOMC to reach a consensus about the long-run optimal size of its balance sheet before starting the unwinding process. Even if some of the more exotic arguments for maintaining a large balance sheet are rejected, the FOMC may still ultimately agree that the optimal balance sheet need not be radically smaller than its current level. If so, then the process of shrinking the balance sheet need not be rapid or urgently begun.
The punchline: "There is little evidence that, at current levels, the Fed’s balance sheet poses significant problems for market functioning or for the economy."
Which is to be expected: after all with the market only able to absorb an occasional rate hike once a year, and that thanks to massive, record QE still ongoing at the ECB and BOJ, the last thing Bernanke would want is to risk the market undergoing a true normalization, one which would send bond yields soaring as the buyers of last resort becomes seller of first resort, while equities do the opposite of what they did since 2009.
Ultimately, Bernanke is right: for all the Fed's trial balloons, don't hold your breath for a balance sheet "renormalization" to take place any time soon.