That Federal Reserve Chairman Jerome Powell came across as “aloof on the stock market sell-off” in his press conference after the Federal Open Market Committee meeting on Wednesday, or that he was being “too rigid with a balance sheet on auto-pilot” were common criticisms by more than a handful of analysts or commentators to explain the sell-off in the global stock markets.
The heightened volatility was enough to send New York Fed President John Williams out to face the cameras on CNBC just now to not only offer a more dovish takeaway from Wednesday to calm the markets, but also to suggest that there is a possibility of changes to the Fed’s “baseline plans” for balance sheet normalization if there was a “material” change to their forecasts.
Two points to put some flesh on the Fed’s balance sheet policy and in particular, whether it is removing liquidity from the stock market and other asset markets:
*** First, there are very few Fed officials or staff who in fact see a material linkage between the very gradual, balance sheet run-off of maturing assets and any significant impact in draining general market liquidity that could be driving the weakness in the stock market or other asset markets. As we noted recently (12/10/18, “Fed: December Expectations”), there is assumed to be some tightening effects in the balance sheet shrinkage, but it is believed to be marginal at best. And there are no significant liquidity effects seen in slowly removing excess reserves from the banking system and the market appetite for risk assets. ***
*** That said, however, that Williams just days after the December meeting offered a clearer caution on further rate hikes and a potential flexibility on balance sheet policy underscores the extent to which the commentary blaming the Fed for the market volatility caught Fed officials off guard. In particular, there is a growing recognition that the efforts to keep balance sheet and rates policies on parallel but distinct tracks could complicate messaging next year, especially if there is a pause in rate increases. There is also likely to be more detail and perhaps an acceleration in the decision on the eventual operating framework and optimal size of the balance sheet next year. ***
QE versus “QT”
Fed officials generally believe the three QE programs provided crucial, though perhaps limited, additional accommodation in pushing down the term premium once rates were pinned down to the Zero Lower Bound. But one of the key lessons drawn from the unconventional policies undertaken in the wake of the Financial Crisis was that most of the impact of the large-scale asset purchase programs was in lending credibility to the forward guidance that rates would be kept “lower for longer.”
In that sense, QE as a policy tool was finally perfected in the QE3 program that framed the “open-ended” asset purchases within the Numerical Thresholds to bolster the guidance that rates would be kept “lower for longer.” In turn, working through a “portfolio rebalancing channel,” the Fed’s absorbing duration risk through the longer dated asset purchases lessened the safe haven flight of cash and drove investment back into higher yielding assets that would, in theory, generate greater economic activity.
While the FOMC ultimately decided to include renewed asset purchases and another expansion of the balance sheet as a policy option in its June 13, 2017 “Addendum to the Policy Normalization Principles and Plans,” the FOMC was largely silent on the likely or possible tightening effects of the slow shrinkage in the balance sheet through the stepped up, quarterly run off of treasuries and mortgage-backed securities that was launched in October 2017.
When the initial debate was underway on the merits of large scale asset purchases, staff did extensive work trying to best estimate the impact of the LSAPs on the yield curve and currency exchange rates, which more or less concluded the impact would be minimal but still better than the alternative of doing nothing. The latter was not seen as a viable policy alternative in any case, especially when Congress was reversing fiscal policy into a restrictive stance at the same time that was undercutting the early momentum to the recovery.
Much of that initial work has since been applied in trying to gauge the effects of the balance sheet run-offs. And the conclusion to date has been that while the $85 billion a month in asset purchases, coupled to the perfected forward guidance of QE3, was going to be a relatively small impact, the run-off in $6 billion a month in treasuries building up to a $30 billion a month cap ($50 billion when including MBS) would be significantly smaller still, especially when accompanied by forward guidance stressing its non-role as a policy tool, and in an economy that by then was that much larger.
Currently, the Fed Board and district staff do include some degree of balance sheet tightening into their rate projections that are presented in the quarterly Summary of Economic Projections. But there are no hard and fast rules or equations in doing so, and each is left to their own to forecast its impact, and to adjust their understanding of the data or financial conditions.
But they are unsure of its exact effects, since such a “quantitative tightening” has never been done before. And that is one of the reasons Fed officials are keen to let the maximum $50 billion a month in asset run-offs continue through at least the first six months of next year, to get a sense of its effects on financial conditions that may or may not be incorporated into rates policy path.
There is, however, general skepticism there is any exact mirror effect on the tightening effects in withdrawing excess reserves from the banking system as there was in the QE programs to ease monetary policy. The main reason goes back to the assumed potency of the QE programs: that it was primarily due to the supporting role of the asset purchases to the forward guidance policy messaging; the very gradual run-off of assets by definition lacks the explicit signaling the balance sheet was being used as a policy tool. Or that was the intent at least, until now.
Policy Signal Lost Amid the Noise
As we noted immediately after the FOMC meeting earlier this week (SGH 12/19,18, “Fed: The Persistence in Low Inflation), the FOMC in all likelihood may have thought they had crafted a carefully balanced policy message in lifting rates as well telegraphed, but softening the rate move with the indications of fewer rate hikes next year in the 2019 rate dot median falling from two to three (they must be thanking their stars the median did not stay at three), all coupled with a modestly flattened rate trajectory across the forecasting horizon and a lowered longer run estimate of neutral to boot.
Powell also made a point to note the Fed has taken on board the tightening in financial conditions, reflected in the lower levels of the projected rate path, and did his best to dismiss the rate dot plots.
But there does seem to be a sense within the Fed that Chairman Powell, put into a near impossible messaging dilemma, nevertheless missed the mark in failing to more fully convey the reasons behind the rate policy uncertainty ahead; rates could be paused, quickened or even cut, depending on how the incoming data features into the forecasts underpinning the base case rate path.
And on the balance sheet policy, there was a clear miss in providing more detail on the Fed’s thinking, in part, because our sense is that Fed officials were caught off guard by the suddenness and depth of the views that the balance sheet policy was driving stock prices lower.
Unless markets stabilize through the turn of the year, there is little doubt there will be a mounting concern among Fed officials they may have lost control of its messaging at a potentially critical moment of could prove to be an inflection point in policy.
Indeed, it would be a worrisome development for Fed officials if the balance sheet policy narrative would shift from shrinking the balance sheet to the minimal levels necessary to execute monetary policy to needing to provide plentiful reserves to underpin asset prices. It would literally be the realization of the deepest moral hazard fears among what’s left of the Fed’s old guard of institutional hawks about having turned to the balance sheet as a policy tool at all.