The next chairman will have to decide how many assets to shed
NINE years ago, in the autumn of 2008, the Federal Reserve was fighting a financial collapse. To stave off disaster, it lent aggressively—to banks, to money-market funds, even to other central banks. As a result, its balance-sheet ballooned. At the start of September 2008, the month when Lehman Brothers collapsed, the Fed’s assets totalled $905bn (at the time, about 6% of GDP). By December they had more than doubled in size, to $2.1trn. That was only the start. As its emergency lending unwound, the Fed began purchasing government debt and mortgage-backed securities (MBSs), in an attempt to support the real economy. Three volleys of so-called “quantitative easing” (QE) eventually swelled the balance-sheet to $4.5trn by 2015.
On September 20th the Fed will probably announce that it is putting QE into reverse. It does not intend to sell its assets. Rather, as its securities mature, it will stop reinvesting all of the proceeds. The permitted monthly “run-off” will gradually rise until it reaches $30bn for Treasury bonds, and $20bn for MBSs and housing-agency debt (see chart). The process will not be entirely predictable. Treasuries mature on a known date. But how fast the MBS portfolio shrinks will depend on how many Americans move house or refinance their mortgages (which in turn largely depends on interest rates).
Exactly how QE worked—and hence the effects of unwinding it—remains a little mysterious. The consensus, however, is that asset purchases brought down long-term interest rates, and that the first programme, which began in 2009, had the biggest impact. Fed economists recently estimated that, combined, all the programmes lowered the ten-year Treasury yield by one percentage point.
So as the balance-sheet shrinks, this effect might be expected to go into reverse and interest rates to rise. But there are three reasons to doubt this. First, economists have speculated that some or even all of QE’s potency came from its influence on traders’ expectations for short-term rates. For example, when markets threw their so-called “taper tantrum” in mid-2013, after then-chairman Ben Bernanke said that asset purchases would be reduced, they were agitated in part by the prospect of faster interest-rate rises.
This time, however, there is little scope for the markets to change their assumptions about the path of rates. The Fed has clearly signalled its intentions in advance. Once balance-sheet reduction has started, it will “run quietly in the background”, according to Janet Yellen, the Fed’s current chairman. In any case, markets today view interest-rate rises and balance-sheet reduction as alternatives rather than complements, according to Daan Struyven of Goldman Sachs.
Second, markets have been relatively stable as the Fed has signalled its balance-sheet strategy. The ten-year Treasury yield is 2.1%, almost as low as it has been at any point in 2017. Prospects for tax cuts and new infrastructure spending seem to have moved the markets more than have the Fed’s prognostications. Perhaps earlier QE announcements had an unusually large impact because markets were dysfunctional at the time; today, by contrast, traders can shrug-off balance-sheet policy.
Finally, the run-off will be gradual. Even if the Fed hits its redemption cap every month, it would take eight years to offload all its mortgage-backed securities. This is important if, as many traders believe, it is the flow of central-bank transactions more than its stock of assets that determines prices. (If the stock—which economists emphasise—matters more, the eventual impact on MBS markets looks unavoidable, since the Fed owns 21% of the market.)
The Fed will almost certainly shed its entire mortgage portfolio eventually. Few economists think it should meddle in housing markets in the long term. But how much of its Treasury holdings is sold depends on where the Fed wants its balance-sheet to end up.
That question will probably be resolved by a new chairman, and an almost entirely new Fed board, next year. After the departure of Stanley Fischer, the vice-chairman, in October (see Free exchange), the board might be left with just three members, rather than the intended seven—an unprecedented situation. A perverse effect, besides the higher workload, is that it could make it hard for board members to confer privately. Any two would constitute a quorum.
Even if the Senate soon confirms Randal Quarles, the president’s nominee to be vice-chairman for bank supervision, three slots would still be open. The vacancies give President Donald Trump latitude to reshape the central bank, and hence, indirectly, its balance-sheet. For now, they increase the power of the five presidents of regional Fed banks who, with the board, vote on monetary policy. They tend to be more hawkish than board members (perhaps because, unlike the board, they are not appointed by politicians).
In February Ms Yellen’s term will expire. Until recently, the favourite to replace her was Gary Cohn, Mr Trump’s senior economic adviser, whose views on monetary policy are not clear. But Mr Cohn has reportedly fallen out of favour with the president, after criticising his response to a white-supremacist march. That might have boosted Ms Yellen’s chances of reappointment. But she, too, has risked the ire of the White House, with a robust defence of financial regulations that Mr Trump wants to loosen. (Her backers hope that a recent breakfast with Ivanka Trump, the first daughter, helped to curry favour.)
The obvious beneficiary of these setbacks is Kevin Warsh, an ex-banker who served on the Fed’s board during the financial crisis and was a confidant of Mr Bernanke. Unfortunately, Mr Warsh’s skills at making friends seem stronger than his monetary-policy acumen. During the financial crisis, he fretted needlessly about inflation. His criticism of asset purchases from 2010 onwards have not aged well. And his muddled writings on monetary policy betray his lack of economic training.
Under Mr Warsh, the Fed might shed assets, especially MBSs, faster. Worryingly, it might also hesitate to use QE again if, as is likely, interest rates hit bottom once more during a future recession—especially if Mr Trump appoints other QE-sceptics, such as Marvin Goodfriend, a professor at Carnegie Mellon University, to the board. Ms Yellen, despite her efforts to shrink the balance-sheet now, would be a better firefighter come the next conflagration.