Commentary: The Fed should never "normalize" its balance sheet

Fed balance sheet normalization is coming. Here's why the Fed shouldn't do it.


1.A big balance sheet makes implementing monetary policy simpler.

First, by targeting rates by simply paying interest on reserves is operationally cleaner. Before 2008, for the most part, the Fed did a very good job of hitting interest rate targets by closely monitoring the amount of liquidity in the banking system. But the real question is why bother. Why bother having large trading staffs, constant coordination with Treasury payments and taxes, bond auction schedules, and the Treasury's cash balance, ect? Most foreign central banks have simply paid IOR to control short term rates. It's goofy for the US to use such a wasteful and inefficient system.

A big balance sheet also provides a large pool of risk free short term assets to the public. The private sector can synthetically supply these assets in the form of repo or MMMFs, but these systems came under severe stress during the financial crisis. Truly risk free zero duration assets ought to be a public utility.  The Fed's massive balance sheet provides that. Why on Earth would we want to go back to the old system?

2.Under IOR, the size of the Fed's balance sheet does not reflect the stance of monetary policy. Nor does it contribute to asset bubbles

The Fed targets rates, not the quantity of reserves. For this reason, adding interest bearing reserves to the financial system does not ease financial conditions, nor does it make it easier for banks to lend. Bernanke never expected banks to 'lend out' the reserves created by QE. In fact, if profitable loans existed, the Fed had already engineered the money market to supply liquidity to the banks at zero interest. Their was nothing that the banks could do after QE that they couldn't do before QE. Under a monetary regime which targets rates, bank credit is price constrained, never reserve constrained. 

Therefore, keeping a large balance sheet and controlling rates by paying IOR does not imply a looser policy stance that controlling rates by closely monitoring (and actively intervening in) the money market. Thus, we can keep the advantages of a big balance sheet which were discussed earlier with little risk of undermining the effectiveness of monetary policy.

Finally, the stupid chart rolling around the internet which graphs the Fed's balance sheet against the S&P 500 index is silly. The conspiracy theorists are contending that hyperinflation is occurring the asset markets instead of the real economy.

As Glenn Hadden points out, we can dispense with this myth with a simple thought experiment. Suppose the Fed announced that it would stop reinvesting all maturing Treasurys and principal in its MBS portfolio. However, one half of the proceeds would be invested in equities.  This would dramatically shrink the Fed's balance sheet, but would make the stock market soar.  The point is that the first order effect is on what the Fed is actually buying. (And closely related assets. Eg, AAA corporate debt in the case of Treasury bonds and notes)

3. The maturity structure of the Federal Government's liabilities could still be used as an economic policy lever. 

First, given that the MBS and Treasury markets are huge, its nonsense to suggest that the Fed must unwind so that it could ramp up purchases to fight the next recession. But, even if the Fed owned the entire Treasury and Agency MBS markets, either the Fed or the Treasury could alter the duration of the consolidated government's liabilities by engaging in swap agreements. (Eg, electing to receive the fixed leg and pay the floating leg to do the equivalent of QE) 

Its also worth noting that a policy of passive roll off to achieve a 'normal' sized balance sheet essentially just punts debt management back to the Treasury, which will make the ultimate decision on how to refinance maturing bonds.  Instead, the United States needs an articulated debt management strategy. Priority one would be figuring out whether the Fed or the Treasury should be in charge of it.  

The Fed wants to normalize its balance sheet. I don't know why. I don't think the Fed knows why either. It reminds of the toxic, innovation killing corporate culture of "well, that's the way we've always done it." When it comes to central bank balance sheets, bigger is indeed strictly better.