The Fed's balance sheet puzzle

Washington (AFP) –


"Stop with the 50 B's"!

President Donald Trump's cryptic exhortation on Twitter recently has shone a spotlight on a complex part of the US Federal Reserve's monetary policy: the reduction of the balance sheet.

By investing up to $50 billion less each month in bonds, the Fed is implicitly pushing interest rates up, which is upsetting Trump who has complained repeatedly about the rising cost of credit.

- Post-crisis stimulus -

In the wake of the 2008 global financial crisis, the US central bank cut interest rates to zero, to encourage loans and investments, and then embarked on an unprecedented strategy to prevent the economy from plunging into recession.

This so-called quantitative easing or QE policy, involved buying up massive amounts of securities, flooding the financial system with cheap money.

The Fed implemented QE in three phases from 2008 to 2014. The Bank of Japan and later the European Central Bank followed suit.

The Fed purchased huge amounts of US Treasury bills and mortgage-backed bonds that swelled its balance sheet.

Its securities holdings surged from nearly $900 billion before the crisis to $4.5 billion by the end of 2017.

- Supporting the economy -

This innovative policy remains controversial, but then-Fed Chairman Ben Bernanke insists QE helped prevent the crisis from becoming even more damaging.

One thing is certain, the billions injected into the economy by the Fed paradoxically favored the stock market.

As bond yields dropped, investors poured more money into equities, in search of a better return on investment.

Once the recovery was solidly underway, the Fed in October 2017 began a process to gradually reduce its holdings. But it has not determined how much it will cut.

- Smooth normalization -

But the Fed did not want to upset financial markets by selling off large amounts of bonds too quickly, and instead opted for a very gradual strategy for what it calls "balance sheet normalization."

The first step was to reduce reinvestments in maturing securities, by small amounts each month. The Fed began by reducing its balance sheet by $10 billion a month and then increased the pace to $50 billion a month -- 60 percent bonds, 40 percent mortgage-backed securities.

The Fed's holdings have come down to about $4 trillion currently.

Former Fed chair Janet Yellen, who presided over the start of normalization, said the process was intended to operate in the background and be as boring as watching paint dry.

Fed Chairman Jerome Powell has said repeatedly that the process was "on autopilot" and in early January said the balance sheet would end up "considerably lower than it is now."

- Indirect effect on rates -

But this process tends to look like a slight rise in interest rates.

Trump has regularly criticized the Fed and Powell for raising rates and endangering the economy, and has more recently complained about this "quantitative tightening."

By reducing its purchases of bonds, the prices fall and the yield, or return, climbs.

Combined with the increases in the benchmark lending rates, which remains the Fed's primary monetary policy tool, the reduction of the balance sheet increases the cost of credit, including the ballooning federal debt.

With rising volatility in financial markets and slowing global growth, there has been more focus on what a decline in the balance sheet will mean for rates, and that has added to rising worries among investors.

Fed officials who now advocate patience on rate hikes, also acknowledge they could review the pace of the balance sheet reduction.

Fed Vice Chairman Richard Clarida said the central bank "will not hesitate to make changes" to the program if needed.