IAFEI Quarterly - 37th Issue

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Press, Journal Article
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equal, the faster the pace of balance sheet run-off, the slower the pace
of rate hikes, and vice versa.
In the words of Janet Yellen from a January speech, “The downward
pressure on longer-term interest rates that the Fed’s asset holdings ex-
ert is expected to diminish over time—a development that amounts
to a ‘passive’ removal of monetary policy accommodation. Other
things being equal, this factor argues for a more gradual approach to
raising short-term rates.” Hiking rates quickly while the balance sheet
shrinks rapidly amounts to too much monetary policy tightening for
the Fed’s tastes.
At the longer end of the yield curve, the“conventional wisdom” seems
to be that“when the Fed stops buying, interest rates rise” because“who
will step in when the Fed steps away?” As we are fond of pointing
out, the conventional wisdom is often wrong. We looked at four his-
torical examples of when the Fed ceased or curtailed purchases, and
in three out of four instances interest rates rose when the Fed was
buying. Further, of the four 12-month periods after buying ceased or
was curtailed, two periods saw interest rates fall (see Figure 4 on page
4). The lesson: investors should infer very little about the direction of
longer-term rates from changes in the Fed’s balance sheet.
HERE’S SOMETHING TO THINK ABOUT
Yes, the Fed’s balance sheet is bloated. But, no, you shouldn’t worry—
at least not about the concerns voiced most often (higher rates). Poli-
cymakers aim to reduce the balance sheet gradually over time. While
most investors focus on the asset side shrinking, we see minimal im-
pact to financial markets.
The real story to watch will be the evolving relationship of the Fed
to money markets. As a result of its big balance sheet, the Fed, for
the first time in its 100-year history, now engages with non-bank,
non-primary dealer participants in the money markets, redefining the
Fed’s relationship with financial markets. Rather than going through a
dealer, money market funds (among others) can directly transact with
the Fed. By lending out securities, the Fed will be able to influence the
bond market more directly. What central banker wouldn’t love more
of this power? To continue this relationship, however, the Fed must
maintain a bigger balance sheet. While there are many unknowns, in-
cluding who will helm the Fed if Janet Yellen departs at the end of
her term in January 2018, we suspect central bankers will learn to
embrace the bigger balance sheet.
SOURCES
1. Indiviglio, D. (2011). PIMCO’s Gross Asks: ‘Who Will Buy
Treasuries When the Fed Doesn’t?’ The Atlantic.
2. Frost, Josh, Lorie Logan, Antoine Martin, Patrick McCabe,
Fabio Natalucci, and Julie Remache (2015). “Overnight
RRP Operations as a Monetary Policy Tool: Some Design
Considerations,” Finance and Economics Discussion
Series 2015-010. Washington: Board of Governors of the
Federal Reserve System,
FEDS.2015.010.
3. “Interest rate control during normalization,” Remarks by Mr
Simon M Potter, Executive Vice President of the Markets
Group of the Federal Reserve Bank of New York, at the
SIFMA Conference on Securities Financing Transactions,
New York City, 7 October 2014.
4. White,L. (2017). A Rejoinder to Andolfatto. Alt-M
5. March FOMC meeting minutes
6. Inquiring minds may wonder whether the balance sheet will
shrink as a share of GDP, not merely in terms of absolute
value. On this basis the balance sheet will indeed move
back toward a more “normal” level over time as the economy
grows .
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