While some retreat in risk assets could be helpful to the Fed, a major plunge could harm the recovery. To avoid that, the policy makers would likely prepare the public for what it intends to do, by—in the parlance of Powell—socializing its intentions with investors.
They may have a ways to go to achieve that.
Speaking to reporters on Jan. 13 after a meeting of the Economic Advisory Committee of the American Bankers Association, Morgan Stanley chief U.S. economist Ellen Zentner said the group broadly agreed that the drawdown would begin mid-year. But there was a wide range of views about how quickly that would proceed.
Zentner, for her part, expects a July announcement laying out an initial monthly balance-sheet reduction of $40 billion, moving up quickly to $80 billion in September. That would be in addition to the four quarter-percentage point Fed rate increases she sees this year.
Weighing QT
Complicating the outlook: some policy makers have described quantitative tightening as a potential substitute for some rate hikes—just as quantitative easing was for rate cuts.
Brian Sack, director of global economics for the D. E. Shaw group, estimates it would take about $600 billion in balance-sheet contraction to approximate a quarter-point rate hike. That compares with the $300 billion estimate he came up with Joseph Gagnon in a 2018 paper for the Peterson Institute for International Economics.
The change is because the Fed has deployed much more QE during the pandemic, and longer-term yields are lower and less volatile than in the past. Sack also cited “evidence that rates have been pretty resilient to Treasury supply changes.”
“The economy is strong enough that the Fed will likely have to hike the federal funds rate substantially, even as it shrinks its balance sheet,” Sack, a former Fed official, added.
Michael Gapen, chief U.S. economist at Barclays Plc, highlights the large amount of cash parked in the Fed’s reverse repo facility—almost $1.6 trillion—as evidence that the Fed can easily proceed with more aggressive QT.
Yield Curve
Some policy makers favor leaning more on quantitative tightening than in the past. One argument for that approach: it could help limit a flattening of the yield curve that crimps banks’ lending margins and thus affect their willingness to provide credit to the economy.
A swift rundown of the Fed’s bond portfolio could press up longer-term yields while policy makers are hiking the short-term benchmark rate. That could preserve margins for lenders, supporting the flow of credit. But a surge in rates across the curve could also damage equities, undermining business confidence.
Powell said this month that plans for shrinking the bond portfolio will be discussed in upcoming policy meetings.
In the end, the economic effects of a balance-sheet drawdown are very uncertain, said former Bank of England policy maker Kristin Forbes. It could be like “paint drying in the background” or could have a bigger impact, especially if markets are unprepared, she said.
“Any movement in that direction should be done extremely cautiously because you will have to feel out the effects as any balance-sheet unwind happens,” said Forbes, who is now at the Massachusetts Institute of Technology.
This article was provided by Bloomberg News.