As the US interest rate panoply appears like it might change – in some cases dramatically so – a larger question is being asked by Goldman Sachs. It is not just that US interest rates are going to be hiked, but also the method by which rates could be adjusted is at issue. Certain methods, such as reducing the historic $1.75 trillion Fed balance sheet, could be accomplished through much less obvious efforts than the public reduction of the US Federal Funds rates.
Fed balance sheet normalization might be part of rate hike methodology
There is a current debate inside the FOMC about Fed balance sheet normalization taking place as Bill Gross flatly said the Fed was not interested in reducing their balance sheets. What might be taking place at the FMOC is a move towards “balance sheet normalization,” a March 18 report from Goldman’s US Economics analysis team led by Jan Hatzius observed.
Essentially, Fed officials have two basic choices when determining how to raise interest rates. They can solely focus the Fed funds rate and leave the job of trimming its sizable bond holdings to a new administration that is expected to come in in 2018, or they can combine ongoing rate hikes with balance sheet normalization efforts that are expected to take place later this year.
The Fed funds rate is the more conventional and generally better-understood method for the US central bank to raise interest rates. But in a world where central bank balance sheet risk is a new issue, there is an argument that balance sheet normalization reduces upward pressure on the US dollar and might result in a lowered risk of popping asset price bubbles.
Will Fed balance sheet normalization take place starting with a new administration?
There are, of course, risks to central bank balance sheet normalization.
If during a transition to new Fed leadership – particularly with regard to the central bank chair, one of three openings in 2018 – the new regime was perceived as favoring aggressive balance sheet normalization it might rattle markets, particularly with regards to asset sales.
“If all decisions are left up to the incoming team, financial markets might experience heightened uncertainty during the transition,” the report stated. “Our analysis shows that asset sales could have significantly more adverse effects on financial conditions than gradual runoff, and the mere risk of such an outcome might set up another ‘taper tantrum.’”
If the Fed decides to go down the path of balance sheet normalization, there are two arguments on achieving their goals:
First, compared with funds rate hikes, balance sheet normalization may allow a quicker return of inflation to the target through smaller disinflationary effects per unit of growth deceleration. The intuition is that currency movements depend relatively more on short-term interest rates than on long-term rates, and currency appreciation weighs on inflation not just through standard output gap channels but also directly through import price pass-through. Second, higher long-term rates may reduce the risk of asset price bubbles. Boston Fed President Eric Rosengren has identified commercial real estate as an area where low long-term interest rates could create imbalances.
Goldman, for its part, doesn’t particularly think the arguments presented are powerful. What they do consider is the practical reality that with Republicans, many of whom have been critical of quantitative easing, now have the opportunity to make new Fed picks, including Governor Tarullo and Vice Chair Fischer, which might result in a rapid balance sheet rundown, potentially through asset sales.
One method the Fed could reduce uncertainty, particularly if it decides to move aggressively on balance sheet reduction, could be to take the path of a gradual balance sheet rundown. They see the risk management case for such an early and gradual runoff dependent on three assumptions: (1) a possible strong preference for a smaller balance sheet among new FOMC members, (2) uncertainty about the impact of the balance sheet instrument, and (3) a preference for avoiding large policy reversals.
“The main conclusion is that an early start to balance sheet normalization can help insure against the risk of excessive tightening in financial conditions, and cooling of economic activity,” they wrote, noting that uncertainty, a potential byproduct of this approach, is a difficult factor to model.
We think there is a strong “risk management” case for an announcement of very gradual balance sheet runoff later this year because establishing an early baseline of slow runoff might substantially reduce uncertainty and stabilize financial conditions during the 2018 Fed leadership transition. Our forecast is that the discussion around reinvestment continues for most of this year and the plan is formally announced in December 2017. At that meeting, we expect the committee to hold the funds rate steady after hiking in both June and September. We expect the quarterly hikes to resume in March 2018. If the committee decides to leave the balance sheet runoff until 2018, contrary to our forecast, we think the risk of a fourth 2017 funds rate hike at the December meeting would increase substantially.