bill lee is chief economist at the Milken Institute.
Illustration by Harry Campbell/theispot.
Published September 26, 2017
While monetary hawks and doves have split (sometimes bitterly) on the direction of Federal Reserve policy over the past decade, pretty much everyone has celebrated the Fed’s policy of transparency in setting and implementing interest rate policy. Indeed, many analysts argue that this visible hand at the tiller has helped push stock markets to new highs and allowed long-term interest rates – the money market’s expectation of interest rates and inflation far down the road – to hug cyclically low levels for some time.
I am not especially worried that the monetary waters are about to be roiled. But I do see the faint signs of trouble in the Fed’s announcement last week that it would begin to reduce the size of its bond portfolio, which was pumped up to astounding size during the Great Recession in order to (wisely) supplement the flagging impact of conventional monetary stimulus.
The decision itself was unremarkable, highly anticipated, and, not surprisingly, it hardly fazed the capital markets. But it points to a nagging underlying issue. While, thanks to Fed transparency, the markets have a good idea where the Federal Open Market Committee (FOMC) is heading on interest rates, market actors don’t know how the Fed will manage the ultimate size of the vast overhang of liquid assets in the Fed’s portfolio because the Fed hasn’t said. And though Wall Street didn’t blink at Janet Yellen’s announcement of a slow runoff, it’s worth remembering that it did have a “taper tantrum” in 2013 when former chair Ben Bernanke hinted that the Fed’s balance sheet would have to stop expanding sometime in the future.
Policy Refresher 101
Markets have understood Fed policy to focus mainly on interest rates; the nominal interest rate is set equal to the “real” rate (determined largely by economic growth and productivity) plus the expected inflation rate. However, in 2008, the imperative was to flood the markets with liquidity to reverse the decline in the price of housing and other assets and thereby boost aggregate demand for goods and services in the stunned economy. And after initial misgivings, most economists were unconcerned about “quantitative easing” (QE) and the resulting explosive growth of the Fed’s portfolio of liquid securities. Indeed, other major central banks embarked on similar balance sheet expansions (e.g., the European Central Bank and Bank of Japan). Subsequently, asset prices stabilized and have since risen to new historical highs.
Now that the Fed has begun to pare its humongous balance sheet, market responses have been muted – presumably because the Fed has assured one and all that the unwinding process will be slow. But nothing in those assurances serves as a transparent formula for determining the ultimate size of the balance sheet or even a more precise sense of what “slow unwinding” might mean. For example, during quantitative easing, long-term interest rates declined (as intended), in part, because the term premium (the gap between the level of expected future Fed policy rates and the level of the long-term rate) narrowed. Yet the term premium appears to have been unaffected by the anticipated announcement that quantitative easing will begin to reverse in October.
Markets now face numerous sources of rising uncertainty, many of which are associated with geopolitical events and prospects for U.S. fiscal policy. And I worry (a bit) that a severe market correction finally may manifest, once investors assess the consequences of the additional uncertainty associated with not knowing the ultimate size of the Fed’s balance sheet.
Through a Glass Darkly
So how far can we expect the balance sheet unwinding to go? The Fed’s not telling – probably because it doesn’t yet have specific strategy or theoretical framework in mind. The closest we (and probably the Fed) have to a plan is the amended guideline issued after the FOMC’s June 2017 meeting for shrinking its balance sheet:
[The FOMC anticipates reducing its balance sheet] … to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system's demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future.
This vague statement suggests that its balance sheet reduction strategy will be data-dependent, yet still rely on seat-of-the-pants judgments that will change over time, sometimes dressed up as an “adaptive” methodology. Most market analysts currently estimate that, over the next several years, it is likely that the FOMC will reduce its $4.5 trillion balance sheet to the $2.5 to $3.5 trillion range, which is two to three times its pre-2008 crisis level of approximately $900 billion. After that, it is likely to grow again “to meet the banking system’s demand for reserve balances.”
The Fed’s acknowledged openness to rethinking its position in the wake of new data implies there is to be a whole new dimension to Fed policy that won’t be transparent.
But take these numbers for what they really are: guesstimates. While we can be pretty sure that, barring a reversal of the economy’s fortune, the balance sheet will shrink substantially over the next few years, the Fed’s acknowledged openness to rethinking its position in the wake of new data (inflation? GDP growth? unemployment? the dollar’s exchange value?) implies there is to be a whole new dimension to Fed policy that won’t be transparent.
Back to the Future?
Actually, it may imply a whole new era of less-than-transparent monetary policy, formerly called “constructive ambiguity.” The timetable and pace for Fed interest rate normalization depend critically on steady increases in inflation and the real interest rate from their current low levels. The FOMC has indicated that it believes the federal funds rate should rise to the vicinity of 3 percent (2.5-3.5 percent) in the “longer run.” With its target inflation rate set at 2 percent, this implies that the target for the equilibrium real interest rate is near 1 percent. However, researchers at the San Francisco Fed estimate its current and recent level to be closer to zero.
Apparently, persistent low inflation is defying the conventional assumption that prices will rise as labor market slack diminishes. As low inflation lingers, it reduces confidence in projections for inflation to rise steadily toward the 2 percent target any time soon. Consequently, speculation is growing that the FOMC will adjust its inflation and real-rate targets, lowering the long-run nominal target policy interest rate. The FOMC’s “dot plot” for September shows that the median forecast for the “terminal” interest rate is now one-quarter percentage point lower than it was last June. Such a downward drift may continue as the reality of a near-zero real interest rate and below-2 percent inflation becomes more accepted.
The desirability of running down the Fed’s balance sheet thus remains questionable. Ultimately, the portfolio will likely grow with the monetary needs of the economy. So why go through such pains to shape market expectations for a gradual multi-year reduction, only to reverse course later?
Arguably, the size of the balance sheet should be left unchanged until the banking system’s demand for reserves oblige the FOMC to add assets to match rising liabilities. Such an alternative to the FOMC’s seat-of-the-pants strategy has the advantage of avoiding confusion regarding the degree of monetary tightening in place at a given time. Indeed, even the FOMC is uncertain about the tradeoff between rate increases and balance sheet shrinkage – and their impact on inflation, the real economy and asset prices.
Notwithstanding ongoing balance sheet uncertainty, a low interest rate environment encourages investors to continue building leveraged portfolios that offer the possibility of above-market returns. Finance theory teaches us that well-functioning markets require investors to incur more duration-, liquidity-, and sector-specific risks in order to achieve higher expected returns. These risk factors are usually difficult to quantify and estimate accurately, but regulators are generally not overly concerned because sophisticated investors are assumed to be able to assess these risks. However, regulators do worry if banks are exposed to more risk in the process – especially if banks in question are systemically important (translation: too big to fail).
Reading the Proverbial Tea Leaves
To my way of thinking, the mix of new uncertainty regarding Fed portfolio unwinding, and the old uncertainty caused by chronically low inflation and productivity growth, is raising some troubling possibilities.
As asset prices rise, financial markets appear to be accepting the possibility that the current level of low interest rates will be in place indefinitely. Accordingly, banks will be tempted to lend for leveraged investments (such as private equity that promises above-market returns) to take advantage of today’s potentially long-lasting low-rate environment. That’s probably not an immediate threat: the current low inflation and low interest rate environment could sustain historically high levels of corporate leverage and asset valuations.
But as financial markets enter waters muddied by uncertainties about monetary policy, heightened macroprudential vigilance will be needed. One big question, then, is whether regulators will be up to the task – and whether Congress and the White House will support them.