It’s Time For The Fed To Shrink Its Balance Sheet
Mar 12, 2017
Norbert Michel , Contributor
I follow the evolution and devolution of monetary and financial policy .
Opinions expressed by Forbes Contributors are their own.
A new debate is heating up over whether the Federal Reserve should continue holding on to all those assets it purchased after the 2008 crisis.
Last year, at the Fed’s annual fly-fishing conference in Jackson Hole, Wyo., central bankers debated “the optimal long-run size of the Fed’s balance sheet.” Former Fed Chairman Ben Bernanke sided with those who want to keep the Fed’s balance sheet abnormally large, relative to its pre-crisis size.
Last month, St. Louis Federal Reserve Vice President David Andolfatto added his own reasons for keeping the larger balance sheet.
But Professor Larry White, blogging at Alt-M, has two excellent posts making the counter arguments. As he points out: “We cannot infer from experience since 2008…that the risk is so negligible that the returns surely more than cover the risk.”
In other words, the case for keeping the Fed’s balance sheet bloated hinges on assuming that there is no risk. But there is risk, and the fact that the Fed can shift it onto taxpayers does not make its current “profits” from borrowing short and lending long look any better.
For those not well-versed in this topic, here’s a quick recap of how we ended up with an engorged Federal Reserve.
•In December 2008, the Fed announced it would start buying up long-term Treasuries and Fannie and Freddie mortgage-backed securities (MBS).
•In November 2010, the Fed announced it would do more of the same.
•In September 2012, it doubled down and started buying even more.
•At the end of this buying spree, the Fed’s balance sheet was roughly five times the size it was prior to the 2008 financial crisis. (Its total assets exceeded $4 trillion, up from less than $1 trillion before the crisis.)
•As a result of these policies, ostensibly undertaken because the economic recovery was too sluggish, the Fed now holds nearly $4.5 trillion in total assets, with approximately $2 trillion in MBS.
•The Fed now holds long-term securities whereas, traditionally, its portfolio consisted almost exclusively of short-term Treasuries.
For a bit of perspective on the Fed’s holdings, the commercial banking sector holds about $1.7 trillion in MBS and Treasuries. That’s all commercial banks’ combined holdings.
The enormous size of the Fed’s balance sheet—both real and relative—is cause for concern. Among other things, it means that the federal government has greatly expanded its footprint in credit markets. The Fed brain trust understood this when it undertook its expansion, and did all it could to signal that the Fed would normalize its balance sheet—i.e., sell the newly purchased assets—after the economy recovered. In 2009, Bernanke said that:
“However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy– namely, by setting a target for the federal funds rate.
This last sentence is particularly revealing. It’s an admission that the Fed’s extraordinary expansion killed the federal funds market as it was previously known, thus preventing the Fed from conducting money policy as it had in the past. And, of course, it suggests that keeping the Fed’s balance sheet so large will prevent it from easily returning to its traditional policy tools.
Traditionally, a main goal of monetary policy was to keep a small footprint in financial markets and to keep banks’ reserves artificially scarce.
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That policy ensured that the Fed’s open market operations (buying and selling financial assets) could influence the federal funds market, where banks lend and borrow reserves. By creating trillions of dollars in excess reserves via its long-term asset purchases, the Fed eliminated this artificial scarcity.
Now, the Fed relies mainly on paying interest on the excess reserves that all those asset purchases created. This fact becomes a major problem when interest rates rise, and not only for the reasons that White points out in those Alt-M posts.
Just think of the politics. In 2013 and 2014, at an interest rate of 0.25 percent on more than $2.5 trillion in excess reserves, the Fed paid banks $5.2 billion and $6.7 billion, respectively.
These amounts pale in comparison to how much it could be if interest rates rise.
If short-term interest rates rise to, for example, 3.5 percent, the Fed would have to pay a similar rate on excess reserves or risk higher inflation. And at that rate, Fed payouts to large banks would climb to about $100 billion a year. (It’s worth pointing out that the Fed can’t simply make interest rates whatever it wants them to be, and while rates remain historically low, they’ve been on an upward trend for close to two years.)
Payments of that size would be a political nightmare, even if Sens. Bernie Sanders (D-Vt.) and Elizabeth Warren (D-Mass.) decided to ignore them.
Regardless, this brave new world of monetary policy highlights a fundamental economic problem that many U.S. policymakers refuse to address: Once it starts, government involvement in the private economy tends to expand.
Too often, the Fed gets a pass because monetary policy is so mystical and because the Fed has a quasi-governmental status. But the final backstop for the Fed is the U.S. taxpayer.
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And when the Fed expands its economic footprint to the degree it has, even people with little grasp of the intricacies of monetary policy can sense something has gone wrong.
Any private financial institution that undertook such a risky financial expansion in such a short time would come under incredible scrutiny by the Federal Reserve. Yet, somehow, Americans are supposed to believe that is beneficial for the Fed itself to make the same financial gamble.
It is not the job of the U.S. government, or any of its agencies, to take financial risks in the hope of making money for taxpayers. Taxpayers can do that on their own when the government gets out of their way.
The Fed should have started selling off these assets a long time ago, but it didn’t. The good thing is that it’s not too late. Yet.
Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.