What is the one thing that most people find fascinating about history? It probably has to be the subtle way, in which it interacts with the present and leaves indelible traces on the future. Take the Great Recession for example: In early 2000s, when the US economy faced minor recession, the Federal Reserve reduced its interest rates 11 times in a span of a year. This attracted a horde of subprime borrowers to borrow money from banks to realize their dreams of owning a house which resulted in a housing bubble. When this bubble burst, the result was one of the worst recessions ever post the Great Depression of 1929. The fund market took a severe blow as consumer spending, business investment and industrial production came to a stand-still. To restore confidence, risk taking and money supply, the Fed undertook, what is called ‘Quantitative Easing’, to wit, money printing. In the period 2008-2010, the Fed purchased US treasuries and mortgage – backed securities in three rounds (around $3.7 trillion). Consequently, the Fed’s balance sheet swelled up to five times its size prior to the Recession and, presently, it stands at $4.5 trillion.

As the economy picked on its recovery, the Fed intended​ to tighten its monetary policy by increasing its interest rates (which had reached as low as 0-0.25% during the recession) so that the low rates doesn’t herald inflation. The economic recovery is also encouraging the Fed officials to finally consider reducing the size of its balance sheet. But this is easier said than done. Firstly, there have been some debates if the Fed should really consider reducing the balance sheet size. Some, for example the former Fed Chair, Ben Bernanke, is of the opinion that a larger balance sheet would benefit the Fed by imparting financial stability and by enabling it to perform its function of ‘the lender of the last resort’. In case of uncertainty, when due to low liquidity, financial institutions engage in fire sales (dumping assets at any price), a larger balance sheet would enable the Fed to bring some liquidity into the market. But others disagree with these arguments saying that large asset holding could mean running a risk of financial losses.

Secondly, an incident has warned us of how ugly things could turn in the blink of an eye. In 2013, when the news got out that the Fed was planning on using tapering (gradually reducing the amount of money it feeds into the economy), it resulted in what is now known as ‘Taper Tantrum’. There was a sudden surge in US Treasury yields as people (fearing that without the Fed’s support, the bond market could become volatile) started withdrawing their money from the market. Hence the Fed officials have to be very careful to achieve its objective without bringing chaos across the markets. So how do they go about it?

One method (popular among the Republican leaning economists) is that the Fed should actively sell its assets to quickly reduce the balance sheet. This method however could have serious implications for the economy as it could interfere with the prices in the bond markets, leaving behind a highly unstable market. According to Ben Bernanke, this sudden move could result in a second case of Taper Tantrum. The other method (the more scrupulous of the two) is to let the securities mature and reduce or stop their reinvestments. This approach can bring a degree of flexibility to the programme. Firstly, the Fed would play a passive role. This way there is no unpredictable large scale changes made in the market. Secondly, most of the US Treasuries have maturities of 5 year or less. This means that the process wouldn’t take too long and would leave room for taking action in case of any contingency.  Thirdly, at a time when economists are divided in their opinion on the optimum balance sheet size, this method would take that into account. While the securities are gradually maturing, the size of the balance sheet wouldn’t reduce immediately. The Fed could intervene to reinvest in some of them if and when it is required to do so.

The FOMC (Federal Open Market Committee) has made its point to shrink the balance sheet but it has also made it clear that it will not proceed with the programme until, “the normalization of the level of the federal fund rate is well under way.” In other words, first the interest rates would increase and then the balance sheet would shrink. The new president of Minneapolis Fed, Neel Kashkari however believes that the first step of the normalization process should be a public communication- a detailed plan of the Fed’s programme should be made public so that the markets have an idea about how the things are going to unfold. In the FOMC meeting on 3rd May, although the target interest rate levels were left unchanged (0.75-1%), throughout the meeting it was indicated that there would a further hike in the rates in the upcoming meeting in June. This time the interest hike was left off the table as the officials were concerned about the “transitory” economic weakness in the economy.   

Since it is the Fed’s balance sheet, central bank of the world’s largest economy, it would be impossible for anyone to reliably predict how the events would turn out to be. The appropriate size of the balance sheet depend on several factors such as its monetary policies, financial situations in the country and how the Fed responds to those. Not to forget that while Fed is dealing with paring the size of its balance sheet, it is also responsible for keeping a check on inflation and unemployment rates as well as the value of USD. Hence the timing to commence the programme is crucial, because once started, there is no going back.

By Arushi Sharma

Image Source: Philosophy of Metrics

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