The Fed’s Balance Sheet Strategy: What Now?

The Fed left its policy rate unchanged at 1.5 percent to 1.75 percent at its May 1–2 FOMC meeting, as expected, and its official post-meeting policy statement reflected an upgraded assessment of inflation conditions.

Since the Fed’s unconventional, emergency purchases of mortgage-backed securities (MBS) and Treasuries at the height of the severe financial crisis in November 2008, the Fed’s perception about a dramatically-enlarged balance sheet has evolved towards believing that it is conventional and normal.  The Fed’s expanded scope of monetary policy has been supported by its over-estimation of the benefits of its Quantitative Easing (QE) asset purchases and its under-estimation of the economic and political risks of maintaining an outsized balance sheet. The Fed’s exposure to Congress’s dysfunctional budget and fiscal policy making in the face of mounting government debt and debt service costs is particularly concerning.  

The Fed’s emergency measures helped end the financial crisis and lift the economy from recession.  In a speech on December 1, 2008, Fed Chairman Bernanke commented that the Fed’s purchases of $600 billion of government-sponsored enterprise debt and MBS were extraordinary, unconventional steps, and stated that “To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed balance sheet would eventually have to be brought back to a more sustainable level.”  

However, these crisis-related instructions have not been implemented.  After financial markets had normalized and economic growth had become self-sustaining, the Fed’s QEs had a different purpose—to stimulate faster growth and improve labor markets.

While QEI, the Fed’s low policy rates, forward guidance and reinvestment policy clearly stimulated financial markets, there is scant evidence that economic growth was stimulated by QEII and QEIII.  

Financial markets thrived during QEIII but the economic responses were muted.   Stock markets and real estate values rose sharply, bond yields stayed low, and risky assets appreciated.  But nominal and real GDP did not accelerate during the four years after QEIII began as the Fed expanded its balance sheet to $4.5 trillion and reinvested maturing assets to maintain that level.  Nominal and real GDP growth averaged 3.6 percent and 2.1 percent, respectively. Most strikingly, business investment did not respond as expected to the lower real costs of capital. The economic effects of QEIII and subsequent reinvestment policy were significantly overstated and raise many questions.  

Nevertheless, the Fed takes credit for the improved labor markets and now favors maintaining an oversized balance sheet.

What began as an unprecedented response to the most severe financial crisis in generations has evolved into what is now perceived to be normal and conventional.  But neither description is appropriate.

The Fed’s current intention--to reduce gradually its Treasury and MBS holdings but indefinitely maintain an enlarged balance sheet, including MBS, with sizable excess reserves--involves new procedures for conducting monetary policy that are simply more complex than are needed for the Fed to achieve its mandate, and they extend the Fed’s footprint in financial markets more than is necessary. The potential risks to the Fed’s credibility and independence overwhelm any possible benefits of maintaining an enlarged balance sheet as contingency planning for infrequent financial emergencies.

There is no justification for the Fed’s sustained holding of MBS, and the Fed should adjust its strategy to move toward an all-Treasury portfolio. The Fed should fully unwind its MBS holdings and reduce its balance sheet consistent with modest amounts of excess reserves.  This would allow the Fed to gradually unwind its overnight reverse repurchase agreement program and re-establish the historic Fed funds rates.  The Fed should not be involved in credit allocation that favors housing over other sectors years after the mortgage market has fully repaired.   Policies affecting credit allocation should be left to fiscal policy and regulators, and the Fed should stay away from the politics of housing policy and credit subsidies.

The Fed has been far from transparent about the sensitivity of budget outcomes and fiscal policies to monetary policy, the economic and financial risks of its enlarged balance sheet and how it encourages bad budget practices.  The Fed’s enlarged balance sheet and the sizable profits it remits to the Treasury are simply too tempting to Congress’s fiscal policymakers, who now perceive of the Fed as a source of risk-free money. The Fed should steer monetary policy clear of fiscal policy—and the most effective way of doing so is to shrink its balance sheet.

The Fed should instead reset its strategy to rules-based guidelines for conducting monetary policy during extended normal times and move back towards its historic procedures that proved efficient in all but extreme circumstances. It should also establish a framework that would allow emergency monetary policies during abnormal economic or financial stress.  

Mickey Levy is the Chief Economist for United States, Americas and Asia at Berenberg Capital Markets. This column is based on a paper delivered to the Hoover Institution’s Policy Conference on Currencies, Capital, and Central Bank Balances on May 4, entitled “The Fed’s Balance Sheet Strategy: What Now?” The full paper can be found here.

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