Cleveland Fed President Loretta Mester said on Wednesday she would like the central bank to quickly reduce its balance sheet so that it returns to a “more reasonable size” as long as the pace does not have a negative impact. in the financial markets.
During the COVID-19 pandemic and the disruptions in the Treasury market, the Fed bought securities. The central bank’s balance sheet doubled to $8.8 trillion.
With the Fed actively planning to back away from its ultra-accommodative policy enacted when the economy shrank during the pandemic shutdown, balance sheet reduction and higher interest rates are on the table.
Financial markets are following the balance sheet debate closely. Trader after trader have appeared on cable networks since 2020 claiming that the Fed’s asset purchases, sometimes referred to as quantitative easing, have bolstered financial asset valuations. And so there is a feeling that the reverse could also be true.
In an interview at the top of The Wall Street Journal’s CFO Network, Mester, who is a voting member of the Fed’s interest rate-setting committee this year, said she wanted to shrink the balance sheet. She added that the Fed could shrink the portfolio at a faster pace than in 2017 because the economy is stronger and the balance sheet is larger.
“I would like to reduce it – let me say this carefully, so people don’t get it wrong – as quickly as possible, provided it doesn’t disrupt the functioning of financial markets,” Mester said.
On Tuesday, Kansas City Fed President Esther George, who is also a voting member of the FOMC this year, supported a rapid pace of balance sheet reduction.
Read: Fed’s George calls for faster withdrawal of assets
The Fed reduced its balance sheet in 2017 by allowing a portion of its maturing securities to exit the balance sheet each month. She did not sell any of her portfolio holdings.
In 2017, the Fed began allowing $10 billion per month rollover and eventually increased it to $50 billion per month. The balance sheet fell from a high of $4.5 trillion in January 2015 to $3.8 trillion in August 2019.
One thing that is different this time around is that the Fed has a new permanent repo facility to provide liquidity to the market if strains arise as the balance sheet shrinks. In the last cycle, strains appeared in September 2019.
There are “rules of thumb” about the amount of balance sheet reduction that would equate to a quarter-point hike in the Fed’s benchmark interest rates. But those studies still point out that it depends on current economic conditions, Mester said.
“I think we have to be humble” about the specific effects of the balance sheet reduction, she said.
“I think what we need to do is figure out an appropriate path to reduce the balance sheet,” and then watch the reaction of the economy when the Fed raises its benchmark rate, she said. Both policy tools will go in the same direction.
With interest rates at zero and the Fed continuing to buy assets through mid-March, the central bank is far from tight monetary policy, she noted.
Fed Chairman Jerome Powell told Congress on Tuesday that the balance sheet contraction could happen later this year. Some Fed officials are pushing for an earlier start.
Read: Powell portrays a soft landing
Michael Gapen, chief US economist at Barclays, said he expects the balance sheet contraction to start in the second half.
He estimated that the Fed might want to take $1 trillion off the balance sheet in the first year.
“I think they might have a pretty fast trickle down rate at the start,” he said in a Bloomberg Radio interview, possibly $60 billion to $80 billion a month after a slower start.
The Fed also has more short-term Treasuries on its balance sheet than in 2017.
“You could get a lot of trickle down pretty quickly just by dropping Treasuries,” Gapen said.
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