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Financial Markets Conference 2022: Normalizing the Fed's Balance Sheet
The Atlanta Fed's 2022 Financial Markets Conference (FMC), A New Era of Financial Innovation and Disruption: Challenges and Opportunities, featured policy panels, academic paper presentations, and keynote speakers who explored various developments having a significant impact on the financial system. This Policy Hub: Macroblog post offers some highlights from the conference keynote speakers as well as an academic paper and policy panel on normalizing the Fed's balance sheet. More information on all of the sessions is available on the conference agenda page, which has links to the various sessions' videos, papers, and presentation materials.
The four conference keynotes touched on a variety of issues. However, because of concern about inflation running well above the Fed's 2 percent target and about how the Fed will respond, a large part of the keynotes addressed monetary policy–related issues. The conference kicked off with a fireside chat featuring Roger W. Ferguson Jr. from the Council on Foreign Relations and Atlanta Fed president Raphael Bostic. President Bostic asked questions touching on all four of the policy themes, taking advantage of Ferguson's diverse background as a former Federal Reserve vice chair and chief executive officer of the Teachers Insurance and Annuity Association–College Retirement Equities Fund. In talking about current Fed policy, Ferguson referred to a survey he led of corporate CEOs that included a question effectively asking if the CEOs think the Fed will successfully bring inflation down. The answer that many CEOs gave is that so many factors and forces are at work they cannot be 100 percent certain the Fed can do this.
Harvard economics professor Kenneth Rogoff gave the Monday night keynote speech on the importance of the political economy. Most of Rogoff's speech recounted the economic and political conditions that led to the current relatively high inflation rates. He concluded by noting that if secular stagnation returns, the Fed could find inflation and market interest rates once again near zero. Should this happen, Rogoff argued, the Fed should be given the tools to drive nominal interest rates well below zero, if necessary, to counteract an economic downturn.
The Tuesday morning keynote , "Inflation and the Policy Response to Supply Shocks," was given by Charles Goodhart of the London School of Economics and Manoj Pradhan, founder of Talking Heads Macroeconomics. In their presentation , they contended that the low inflation rate observed in recent decades was largely the result of a large increase in the labor supply, mainly due to China's integration into global markets. They noted, however, that this growing labor supply is in the process of reversing almost everywhere except in African countries. They contend that this reversal is likely to lead to slower growth, and potentially stagflation, in the medium run.
The final keynote was a fireside chat featuring Bostic taking questions from Julia Coronado of MacroPolicy Perspectives. Their chat devoted considerable attention to the current state of the economy, including both the recent negative shocks to supply and the potential for positive shocks to supply. One potential positive shock that Bostic discussed is the adoption of new productivity-enhancing technologies. Coronado pointed to a 2019 conference jointly held by the Federal Reserve Banks of Atlanta, Dallas, and Richmond titled Technology-Enabled Disruption: Implications for Business, Labor Markets, and Monetary Policy. Bostic indicated that at the time of this 2019 conference, monetary policymakers were concerned that technology was disrupting markets in a way that would be adverse to workers' human capital but the current problem is a shortage of workers.
Discussing the Federal Reserve's balance sheet
During and after the financial crisis, the Federal Reserve increased the size of its balance sheet from under $1 trillion to more than $4 trillion. These purchases, part of a process often called quantitative easing (QE), were initially intended to support financial market functioning and later intended to provide additional monetary policy accommodation because the Federal Reserve decided to keep its federal funds target rate above zero. As the economy strengthened in the late 2010s, the Fed reduced its balance sheet to just under $3 trillion in what was often referred to as quantitative tightening (QT). However, with the onset of the pandemic, the Federal Reserve once again expanded its balance sheet to more than $8 trillion in assets. As with the first rounds of QE in the wake of the financial crisis, the initial goal was to support financial market functioning but later focused more on providing monetary policy accommodation.
With a relatively low unemployment rate and inflation rates far above the Fed's 2 percent target, the current focus on policy has shifted to reducing monetary accommodation, which includes shrinking the Fed's balance sheet. Along with several keynote speeches touching on this issue, one of the academic papers presented at the 2022 FMC addressed one aspect of the reduction—the effect of QT on financial conditions—and one of the policy panels examined a variety of issues associated with shrinking the Fed's balance sheet.
Addressing the Unexpected Supply Effects of QE and QT
One challenge with analyzing the effect of monetary policy on the financial system is that market participants often partially anticipate policy moves, and market prices might at least partially incorporate the moves before a policy move is even announced. Stefania D'Amico of the Chicago Fed and her coauthor Tim Seida sought to get around this problem in the cases of QE and QT by looking at unexpected changes in the supply of Treasury securities at specific maturities in their paper "Unexpected Supply Effects of Quantitative Easing and Tightening ." D'Amico explained that their methodology sought to identify the effect of QE and of QT by looking for kinks in the yield curve arising from the unexpected changes in supply. They found that Treasury yields are more sensitive to QT surprises than to QE surprises. These effects do not diminish during periods of market calm amid economic expansion but are increased by interest rate uncertainty.
The discussion by Morten Bech from the Bank for International Settlements highlighted the implications of the paper for both US domestic markets and the markets of other developed countries. In domestic terms, D'Amico's paper estimates the average supply effect of about 21 basis points (bp) per $1 trillion in balance sheet reduction, which increases to more than 70 bp when uncertainty about the 10-year Treasury rate is especially elevated. He noted that these estimates are consistent with Fed chair Jerome Powell's estimate of 25 bp per $1 trillion (which Powell says has "very wide error bands") and one market participant's range of 7 bp to 42 bp per $1 trillion. On the international front, Bech noted that the Bank of Japan and the European Central Bank have balance sheets that are significantly larger, as a proportion of their economies, than the Fed's. Thus, QE and potentially QT are not only a US issue but one relevant to other major central banks.
Examining Challenges during Balance Sheet Normalization
The panel discussion of monetary policy and normalizing—or shrinking—the Fed's balance sheet started with the panel's moderator, Vincent Reinhart from Dreyfus-Mellon, presenting a review of the current situation. Reinhart noted that the unemployment rate had dropped to near prepandemic lows and that inflation rates were at 40-year highs, prompting the Federal Open Market Committee (FOMC) to announce plans to raise its federal funds target rate and reduce its securities holdings.
Cleveland Fed president Loretta Mester provided additional perspective on balance sheet normalization. She observed that the FOMC's planned reduction will reduce securities holdings faster than what occurred after the financial crisis, but that this faster reduction reflects the current strength of the economy and the high levels of inflation. She also observed that the FOMC's statement didn't address two items. First, the announced plan talks only about reduced reinvestment of maturing securities and does not address the issue of balance sheet sales. In the panel's question-and-answer period, Mester observed that such sales of agency securities may be necessary if the FOMC is to meet its goal of having its portfolio consist predominantly of Treasury securities. Second, the FOMC had not set a target for the size of its balance sheet, only that it intends to operate in an environment of ample reserves.
The next panelist, Seth Carpenter from Morgan Stanley, forecast that the peak of the fed funds rate would be about 3.25 percent and that it would take the Fed about two-and-a-half to three years to reach its balance sheet target. He added his belief that financial market prices (except for some credit markets) already reflect most of the effects of the announced changes. Carpenter also suggested that it was unlikely the Fed would engage in the sale of mortgage-backed securities, observing that housing is among the most cyclical of sectors and that tighter monetary policy would likely slow it down enough.
Brian Sack from D.E. Shaw noted that it is not often that a market participant announces a planned reduction in the size of its balance sheet by $2 billion to $3 billion, as the Fed has done. He said he anticipates that QT will likely have a moderate effect on market rates, perhaps raising the 10-year Treasury yield by somewhere in the range of 25 bp to 30 bp. However, Sack observed, the reduction in reserves could lead to a strain in funding markets, like that experienced in September 2019. Sack suggested that although pricing is a clearer signal than balance sheet size per se, the Fed should watch behavior in money markets closely to judge when reductions could lead to strain in the markets.
The last panelist was former Federal Reserve Board governor and current Harvard professor Jeremy Stein, who focused on QT's potential to cause strains in money markets and threaten financial stability. In his view, the villain is the minimum leverage ratio requirement (the minimum ratio of capital to total assets a given bank must hold) imposed on banks by their regulators and especially its effects on the largest banks, which are also critical participants in money markets. Stein noted that the problem with the leverage ratio is that it does not account for the risks different types of assets pose. In Stein's telling, the ratio effectively penalizes banks' holdings of low-risk assets, especially the holding of reserves. Ideally, he said, the risk-based capital ratio that does not impose a similar penalty on low-risk assets would be binding, but he thinks that regulatory policy is unlikely to be changed in such a way that the risk-based ratio would become binding. Thus, Stein suggested that the Fed narrow the gap between the interest paid on bank reserves and the rate with which the Fed engages in reverse repurchase agreements with some money funds and other money managers, which would result in banks holding lower reserves and thereby relaxing the constraint imposed by the leverage ratio.
Please check Policy Hub: Macroblog soon to read my post summarizing the rest of the 2022 FMC. I will highlight three other important issues discussed there: central bank digital currency; environmental, social, and corporate governance (commonly known as ESG) investing; and cybersecurity.
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