For the Federal Reserve, to shrink or not shrink is the question
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Recently, the Federal Reserve has reiterated its commitment to beginning to unwind some of its asset purchases. As with any Fed announcement, the media has scrutinized it for signs of impending doom. Markets, so far, have not reacted strongly.

But market reactions cannot be ruled out. The famous “taper tantrum” — the market reaction to Chairman Bernanke’s announcement that the Fed was planning to slow down and gradually end its asset purchases back in 2013 — raised mortgage interest rates a whole percentage point. That was a big deal for homebuyers and financial markets.

What is this all about? In its efforts to pull the economy out of the Great Recession, the Fed began a set of bond-buying programs called Large-Scale Asset Purchases in 2009. When the dust settled in 2014, the Fed had grown to $4.5 trillion, roughly a quarter of the size of the whole U.S. economy.

Before the crisis, the Fed only had a balance sheet of about $600 billion. So the question is, should the Fed stay supersized, or should it shrink back to its “normal”, pre-crisis self?

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Some readers may wonder how a bank could grow so much in such a short period of time. Private commercial banks would have a very hard time pulling off such a feat. But central banks can create money. The Fed can literally put money into one of its member bank’s accounts at the Fed with a mouse click. And, to put things simply, this is what it did to battle the Great Recession.

 

Back in late 2008, the Fed was faced with an extremely dire and unusual situation. Its main lever to boost the economy, the federal funds rate (FFR), had reached zero. Conventional wisdom held that it would not be possible to lower the federal funds rate below zero — that would mean that lenders would pay borrowers to take a loan!

Additionally, the Fed realized that the key lending markets for recovery involved longer-term loans. Mortgage loans are usually for 15 or even 30 years; the loans companies need to finance investment are also longer-term. The Fed had never tried to control those interest rates directly since it had always been sufficient to control the FFR — the rate banks charge each other for extremely short-term loans.

But this was a new situation. The Fed bought longer-term bonds, mainly U.S. Treasury securities, mortgage-backed securities (MBS) and bonds issued by the government-sponsored enterprises that backed up the mortgage markets, Fannie Mae and Freddie Mac. The Fed’s bond-buying raised the prices of these bonds and lowered their interest rates. Homebuyers and firms enjoyed extraordinarily low interest rates as a result.

Fast-forward to 2017. The financial system has stabilized. Companies have used low interest rates to build up enormous piles of cash. Housing prices have rebounded a great deal and home mortgages are available again, although lenders are more choosey about who gets them then they were before the crisis.

In fact, the Federal Reserve now judges that the economy is nearing full capacity. This means that the extraordinarily stimulative policies of the post-2009 period need to be unwound. The Fed has raised the FFR in small steps, with more increases on the way.

Downsizing the Fed balance sheet would fit into this move to take away the crutches. Since the Fed stopped buying bonds in 2014, it has stuck to a policy of taking the money from any bonds that matured and buying new bonds of the same type. This has kept the Fed’s bond portfolio at a stable size. Now, they plan to simply not replace the bonds that mature. This would take away a support for bond prices, allowing interest rates to rise.

So far, so good. Slimming down the Fed could just be a part of a process allowing interest rates to rise as the economy gets back to good health.

However, there are a couple of sticking points. The first is that the Fed has no desire to move interest rates dramatically. Since they are now a 10-ton gorilla in the bond markets, they have to move carefully. Selling off a significant part of their holdings in a short time could spike interest rates, sending the economy into a downward spiral.

Although this may worry markets a bit, the Fed has, in fact, been very cautious. Also, the profile of the bonds does not require them to move quickly. Of the Fed’s $2.5 billion of Treasury securities, almost half mature in the next 1-5 years.

The Fed should be able to manage the process of runoff, since they know exactly when the bonds mature and can take a variety of actions to offset excessive upward pressure on interest rates, should it materialize.

The aspect that could be a bit more tricky is the unwinding of the Fed’s holdings of MBS. These are bonds backed by bundles of mortgages that are guaranteed by Fannie Mae and Freddie Mac. Almost all of these bonds do not mature for another 10 years. The Fed would like to get these off its balance sheet, because it does not want to be in the business of supporting a particular sector of the economy.

Even though housing is critically important, the Fed is very sensitive to the criticism that it is favoring one part of the economy over others. But it seems unlikely that the Fed will be able to speed up this process too much.

Beyond these somewhat practical issues, there has been a debate about whether it actually makes sense for the Fed to go back to anything like its pre-crisis size. Three arguments have been advanced for keeping the Fed supersized.

First, former Fed Board of Governors Member Jeremy Stein, in a set of papers with Harvard Business School colleagues Robin Greenwood and Samuel Hanson, suggested the Fed can use its large portfolio of Treasury securities to prevent some of the most egregious risk-taking behavior seen during the 2000’s boom.

These authors point out that various financial institutions, such as investment banks (think Lehman Brothers) and insurance companies (think AIG) borrowed money at extremely short maturities to finance their piles of highly risky assets.

If the Fed had its own arsenal of bonds, it could make its presence felt in the short-term liquidity markets (called the repo market), inducing those with extra cash to lend to the Fed rather than to risk-loving financial institutions.

In other words, they argue that the Fed can and should start to actively manage what is often referred to as the shadow banking system, in addition to the conventional banking system that the Fed has traditionally dealt with.

A second argument for keeping the Fed’s balance sheet large, advanced by Darrell Duffie and Arvind Krishnamurthy of Stanford Business School, is that this could make monetary policy more effective. Like Stein and company, they see big advantages to the Fed maintaining its presence in the repo markets. Their focus, however, is on controlling interest rates and credit in the economy. This argument complements that of Stein and his colleagues.

Finally, Ben Bernanke pointed out that keeping a big balance sheet would allow the Fed to come to the aid of shadow banks in trouble. This “lender of last resort” role was a key feature of the Fed’s actions in 2007-08. However, Congress curtailed it in the Dodd-Frank Act of 2010, responding to criticism that the Fed had not been transparent and consistent in its choices to aid particular institutions.

The Fed pushed to the edge of its authority to keep the investment bank Bear Stearns afloat just long enough to allow it to be sold, but did not come to the rescue of Lehman Brothers. In truth, these decisions were not only made by the Fed. The Treasury under Secretary Hank Paulson played a key role in those decisions, especially the decision not to save Lehman.

Matters are now quite different, with the Financial Services Oversight Council, chaired by the Treasury secretary, in charge of activating procedures to rescue or wind-up troubled large institutions under the Dodd-Frank Act.

Bernanke’s proposal would not contradict Dodd-Frank if it provided help to all qualifying institutions, not just one institution in trouble. Central bankers are rightfully unwilling to give up the possibility of providing funds in a crisis, because experience has shown over and over again that providing liquidity is a key step in stemming the escalation of crises.

So far, the Fed has not signaled whether it accepts these arguments. The Fed may feel that staying so large makes it more vulnerable to political attack, mostly from the right. But the central bank’s announced intention of allowing some bonds to run off does not mean that it will move rapidly to shrink itself.

Given the Fed’s aversion to dramatic moves, it seems more likely that any diet will be pretty moderate. For anyone hoping to see the Fed back in its petite-sized bathing suit, I can only say — don’t hold your breath.

 

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.


The views expressed by contributors are their own and not the views of The Hill.