Shrinking the Fed’s balance sheet is unlikely to be a benign process, warns new Jackson Hole study

If the past repeats itself, shrinking the central bank’s balance sheet is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s on- and off-balance sheet liabilities.


— Raghuram Rajan, former Governor of the Reserve Bank of India and former Chief Economist at the IMF

The Federal Reserve wants to be able to shrink its balance sheet in the background with little fanfare, but that may be wishful thinking, according to new research presented at the Fed’s summer meeting in Jackson Hole on Saturday.

“If the past repeats itself, the shrinking of the central bank’s balance sheet is unlikely to be an entirely benign process,” according to the study. Shrinking the balance sheet is “a difficult task,” concludes the paper by Raghuram Rajan, former governor of the Reserve Bank of India and former chief economist of the IMF and other research.

Since March 2020, at the start of the coronavirus pandemic, the Fed has doubled its balance sheet to $8.8 trillion by buying bonds and mortgage-backed securities to keep interest rates low to prop up the economy and the housing market .

The Fed stopped buying assets in March and began a process to gradually shrink the portfolio. Officials see this as another form of monetary policy tightening that will help reduce inflation along with higher interest rates.

The Fed began shrinking its balance sheet in June and is raising it next month to a maximum rate of $95 billion a month. This will be accomplished by letting $60 billion in Treasuries and $35 billion in mortgage-backed securities come off the balance sheet without reinvestment.

That rate could reduce the balance sheet by $1 trillion a year.

Fed Chairman Jerome Powell said in July that the balance sheet reduction could continue for “two and a half years.”

According to the study, the problem is how commercial banks react to the Fed’s policy tool.

When the Fed buys securities under quantitative easing, commercial banks keep the reserves on their balance sheets. They finance these reserves by borrowing from hedge funds and other shadow banks.

The researchers found that commercial banks do not reduce this lending when the Fed has begun to shrink its balance sheet.

That means as the Fed’s balance sheet shrinks, there are fewer reserves available to repay those loans, which are often in the form of wholesale demand deposits and are highly “current,” Rajan said in an interview with MarketWatch about bypassing jackson’s hole. meeting.

During the last episode of quantitative tightening, the Fed was forced to stay the course and flood the market with liquidity in September 2019 and again in March 2020.

“If the past repeats itself, shrinking the central bank’s balance sheet is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s on- and off-balance sheet liabilities,” the paper said.

Partly in response to past stress episodes, the Fed has established a Permanent Repo Facility to allow primary dealers, essentially financial institutions that buy government debt, to borrow more reserves from the Fed against high-quality collateral.

Rajan said this emergency funding “may not be broad enough to reach all the people who are strapped for cash.”

The paper notes that some banks, which have access to liquidity, may try to hoard it in times of stress.

“The Fed will then have no choice but to step in once again and lend broadly as it did in September 2019 and March 2020,” the paper said.

That could complicate the Fed’s plans to raise interest rates to bring inflation under control.

Even more fundamentally, researchers raise questions about the effectiveness of the opposite policy—quantitative easing—as a useful tool for monetary policy. Quantitative easing was used by the Fed to provide liquidity and support financial markets during the 2020 coronavirus pandemic.

Fed officials often justify QE by saying it lowers long-term interest rates and allows more borrowing, but economists have said the evidence for that is thin.

Former Fed Chairman Ben Bernanke once said that quantitative easing works in practice but not in theory.

The paper released in Jackson Hole argues that the evidence shows banks did not increase lending to commercial customers during quantitative easing, but preferred to lend to hedge funds and other firms.

Instead of QE, central banks in Europe and Japan have moved to directly buy stocks and bonds of companies and effectively finance them.

It may be appropriate for the Fed to appeal to fiscal authorities to support activity “as pressure on the quantitative easing sequence when economic transmission is muted can only increase potential financial fragility and the potential for financial stress.”

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