Time to Unwind

The Federal Reserve will begin to pare down its nearly $4.5 trillion balance sheet this month, starting the process of reducing assets purchased during the global financial crisis and later quantitative easing (QE) to help the US economy recover from the “Great Recession.” It’s been almost a decade, and it is time for the unwinding of these positions to begin.

Prior to the global financial crisis, total assets at all Federal Reserve banks totaled well under $1 trillion. Given recent growth, it should ideally be around $1 trillion or a little more now (basically what it takes to grease a $20 trillion economy with modern financial payments technology).

In late 2008, as the crisis escalated and threatened stability, the Fed injected trillions into the system through purchases of treasury securities. Only three months later, asset holdings had more than doubled, topping $2.2 trillion. This part of the expansion was absolutely essential and, along with similar actions by other major central banks, averted a global meltdown that would have made the Great Depression look like a walk in the park. Beginning in 2009, the Fed also began purchasing mortgage-backed securities and pursuing multiple rounds of asset purchases, and total assets continued to rise, reaching about $4.5 trillion in January 2015. The merits of this portion of the increase, or at least its magnitude, can be legitimately debated. The downturn was severe, the recovery was sluggish, and Congress was mired in politics and unable to act. On the other hand, monetary policy is not the best tool to stimulate an economy in this situation.

Part of the Federal Open Market Committee’s (FOMC) agenda during this period was to drive down interest rates to encourage lending and stimulate the sluggish recovery of the US economy. Short-term interest rates were reduced to virtually zero in order to stimulate investment and kept there for almost a decade, and unconventional policy measures were also taken to try to drive down longer-term interest rates.

If left in place too long, these extremely low interest rates and accommodative monetary policy would lead to inflation and other threats to the economy as we begin to hit capacity constraints (which is happening in some sectors), and it has always been the Fed’s intention to return to normal when the time was right. In December 2015, economic conditions had improved enough for the FOMC to raise the target range for the federal funds rate for the first time since December 2008. This was an important milestone, because between September 2007 and December 2008, there had been 10 decreases which shifted the target rate from 4.75% to essentially zero.

The goal is to gradually change monetary policy in hopes that the economy continues to expand and hiring is encouraged, since maximum employment is one of the Fed’s statutory mandates. However, the other component of the Fed’s role is to keep inflation in check, and an overheated economy can cause price escalation. The FOMC has been carefully watching the economy to determine when to take the next step, balancing labor market conditions and business activity with signs of inflation.

On September 20, the FOMC announced that, in October, the process of balance sheet normalization would begin. In announcing the decision, the Fed pointed to continuing strengthening in the labor market, rising economic activity, improving business investment, and expanding household spending. Also, the fact that inflation remains below the target rate of 2% was noted. While the devastation of Hurricanes Harvey, Irma, and Maria has caused severe hardship, storm-related disruptions and rebuilding are viewed as unlikely to materially alter the course of the national economy over the medium term, although conditions will be monitored closely.

Given this view, the FOMC decided to leave the target range for the federal funds rate at 1 to 1-1/4% which remains quite accommodative, to support further strengthening in labor market conditions and manageable inflation. Future adjustments will be based on changing conditions in the labor market and inflation, but low interest rates are likely to be with us for a while.

Scaling back the Fed’s assets will follow plans set forth in September 2014, when the FOMC released a very clear statement regarding how the normalization would occur. This original statement was supplemented in June 2017 by the “Addendum to the Committee’s Policy Normalization Principles and Plans” which sets for the expected pattern for gradually reducing the Fed’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities currently held.

While changing the target range for the federal funds rate will remain the primary means of adjusting monetary policy, the FOMC has indicated that it is prepared to resume reinvestment of principal payments received on securities if the economic outlook worsens. As always, the Fed tries to be very clear with its plans in order to avoid shocking financial markets.

Reducing the balance sheet will test the economy and financial system. When the Fed stops reinvesting in securities, liquidity is reduced. It’s a necessary step, because the Fed has several trillion more in assets than it needs on a long-term basis. It is clearly a “Goldilocks” situation – the change must be not too fast and not too slow – as excessive movement in either direction will be disruptive. Unless there is a major shock to the economy, I think growth will continue even with the additional layer of normalization. And if it doesn’t, the Fed stands ready and willing to respond. It is back in its wheelhouse, doing what it does best.