I didn't coin the title of this blog post. It was the label on a chart of the Federal Reserve's balance sheet that appeared in an issue of The Wall Street Journal last week. I've led with this phrase because it does seem to capture some of the sentiment around what has become the elephant in the monetary policy room: Is the rundown in the size of the Fed's balance sheet causing an unanticipated, and unwarranted, tightening of monetary policy conditions? I think the answer to that question is "no." Let me explain why.
In June 2017, the Federal Open Market Committee (FOMC) determined that it was appropriate to begin the process of reducing the size of the Fed's balance sheet, which had more than quadrupled as a result of efforts to combat the financial crisis and support the subsequent recovery from a very deep recession.
As I noted in a speech last November, I see the Committee's strategy for shrinking the balance sheet as having two essential elements.
- First, the normalization process is designed to be gradual. It was phased in over the course of about a year and a half and is now subject to monthly caps so the run-down is not too rapid.
- Second, the normalization process is designed to be as predictable as possible. The schedule of security retirements was announced in advance so that uncertainty about the pace of normalization can be minimized. (In other words, "quantitative tightening" is decidedly not on the QT.) As a result, the normalization process also reduces complexity. Balance-sheet reduction has moved into the background so that ongoing policy adjustments can focus solely on the traditional interest-rate channel.
In his recent remarks at the annual meeting of the American Economic Association, Chairman Jerome Powell was very clear that the fairly mechanical balance-sheet strategy adopted by the FOMC thus far should not be interpreted as inflexibility in the conduct of monetary policy or an unwillingness to recognize that balance-sheet reduction is in fact monetary policy tightening.
I will speak for myself. Balance-sheet policy is an element of the monetary policy mix. The decision to adopt a relatively deterministic approach to balance-sheet reduction is not a decision to ignore the possibility that it has led or might lead to a somewhat more restrictive stance of monetary policy. It is a decision to make whatever adjustments are necessary through the Fed's primary interest-rate tools to the greatest extent possible.
I maintain that there is still wisdom in this approach. The effects of our interest-rate tools are much more familiar to both policymakers and markets than balance-sheet tools are. That, to my mind, makes them the superior instrument for reaching and maintaining our dual goals of stable inflation and maximum employment. It is my belief that reducing the number of moving pieces makes monetary policy more transparent and predictable, which enhances the Committee's capacity for a smooth transition toward those goals.
It should now be clear that nothing is written in stone. Whether the FOMC uses active interest-rate policy with passive balance-sheet policy or uses both instruments actively, policy decisions will ultimately be driven by the facts on the ground as best Committee members can judge, and by assessments of risks that surround those judgments.
In my own judgment, it is far from clear that the ongoing reduction in the balance sheet is having an outsized impact on the stance of monetary policy. I think it is widely accepted that one of the ways balance-sheet policies work is by affecting the term premia associated with holding longer-term securities. (There are many good discussions about balance-sheet mechanisms, including this one by Edison Yu, which can be found in the first quarter 2016 edition of the Philadelphia Fed's Economic Insights, or this article by Jane Ihrig, Elizabeth Klee, Canlin Li, Min Wei, and Joe Kachovec in the March 2018 issue of the International Journal of Central Banking.)
Lots of things can push term premia up and down. But one of the factors is the presumed willingness of the central bank to purchase long-term securities in scale—or not. The idea that running down the balance sheet tightens monetary policy is that, in so doing, the FOMC is removing a crucial measure of support to the bond market. This makes longer-term securities riskier by transferring more duration risk back to the market, which raises term premia and, all else equal, pushes rates higher.
Although estimating term premia is as much art as science, I don't think the evidence supports the argument that these premia have been materially rising as a result of our normalization process. The New York Fed publishes one well-known real-time estimate of the term premia associated with 10-year Treasury securities. But isolating and quantifying the effect of balance-sheet changes on term premia is challenging. It is possible that a number of factors, such as the continued high demand for U.S. Treasuries by financial institutions and a low inflation risk premium, might have dampened the independent effect of balance sheet run-off. But if the term premia channel is a critical piece of what makes balance-sheet policy work, I'm hard pressed to see much evidence of financial tightening via rising term premia in the data so far.
Lest anyone think I am overly influenced by one particular theory, I will emphasize that I am not taking anything for granted. In addition to my monitoring of developments on Main Street, I will be watching financial conditions and term premia as I assess the outlook for the economy. My view is that a patient approach to monetary policy adjustments in the coming year is fully warranted in light of the uncertainties about the state of the economy, about what level of policy rates is consistent with a neutral stance, and about the overall impact of balance-sheet normalization. This patience is one of the characteristics of what I mean by data dependence.