ANALYSIS: Fed Leaning Towards Leisurely Shrinking Reinvestmnts

–Officials Emphasize Smooth, Flexible Process After May Meeting

By Jean Yung

WASHINGTON (MNI) – The discussion over how the Federal Reserve should reduce its massive balance sheet sat near the top of the agenda of the May Federal Open Market Committee meeting, with policymakers hinting in recent comments the process will be gradual, with modest monthly reductions and allowing for flexibility based on financial, but not economic, conditions.

Fed officials have reiterated that the balance sheet wind-down will likely commence later this year or in early 2018. At the same time, some officials have also flagged the possibility that the Fed could utilize new rounds of asset purchases to combat future economic slowdowns.

Several crisis-era rounds of quantitative easing, which targeted Treasuries and mortgage-backed securities, enlarged the Fed’s balance sheet by a total of $4.5 trillion, including $2.5 trillion in Treasuries and $1.8 trillion of agency mortgage backed securities.

Estimates of the optimal "long-run" size of the balance sheet vary. Former Philadelphia Federal Reserve Bank President Charles Plosser suggested it needs to be only "big enough to satisfy reserve demand," or around $2 trillion. The risk of keeping it larger than that, he argued at the Hoover Institution’s annual monetary policy conference this month, is that then the Fed could be tempted, or forced, to use balance sheet for other things.

Former Fed Chairman Ben Bernanke has argued the Fed could actually keep its balance sheet large indefinitely, but said in an interview on CNBC this month that he thinks the FOMC is aiming "for something in the vicinity of $2.3 to $2.8 trillion."

Current policymakers have not given a clear signal whether they plan to announce a desired resting level of the balance sheet, but they seem more united on selecting a very slow pace to run down their holdings, starting with reducing the amount of maturing securities they reinvest.

"I think that we might be well-served by smoothing out the maturing proceeds and make sure that it’s a little more in line with what markets can digest easily. … It would be reasonable to have an amount that you would take out of the balance sheet each month that would be easily digestible, especially by the Treasury," Chicago Fed Bank President Charles Evans said Friday.

"Making sure that the path of the balance sheet down is going to be gradual but sufficient to get to a more normal level before too long — I’d say within three to four years — that would be gradual," he said.

William Dudley, chief of the New York Federal Reserve and also a voter on the FOMC, assured investors last week, "We want this very much to run in the background, to be a very modest, minor event rather than a major event."

"So I think that you’ll see us pursue this with great care and caution in the months ahead," he said, according to a Bloomberg account of his talk in Mumbai.

The modal expectation of the New York Fed’s March survey of primary dealers was the Fed would reduce its portfolio by $675 billion by the end of 2019, with about 70% of those surveyed expecting reinvestments to be phased out over time. That would average out to a modest $28 billion monthly pace, assuming the process begins in January 2018.

The extra caution is warranted given the FOMC plans to pursue gradual rate hikes in parallel.

Dudley in April first raised the possibility that the Fed would take a "little pause" in rate hikes when it unveils its balance sheet plan, causing investors to mark down the number of hikes the Fed might push through this year.

He quickly walked back his comments a few days later, saying, "Some people misconstrued what I said last week. I said a little pause. A pause is pretty short already; I think a little pause is even shorter than that."

Since then, some officials have argued even a little pause may not be necessary.

"We don’t know enough about what that trade-off would actually be" between rate hikes and balance sheet reduction to warrant a pause in rate hikes, Loretta Mester, president of the Cleveland Fed and not an FOMC voter this year, said on May 8.

"Frankly if we reduce the balance sheet in this predictable, gradual way, I don’t see that it’s going to have that big of an impact on the economy at this point," she said.

Boston Fed’s Eric Rosengren, another nonvoter, argued May 9 if the reinvestment phase-out is undertaken in a "highly tapered" fashion, starting relatively soon, it would have a small impact on markets.

"As long as the balance sheet reduction is not steep, it should have only modest effects on credit markets," meaning it would have so little impact on financial conditions that the Fed could still use short-term interest rates as its primary tool for adjust the level of monetary accommodation.

As for timing, Rosengren wants the reduction in reinvestments to begin after one more rate hike, he said last week.

Patrick Harker, head of the Philadelphia Fed, indicated Friday he could be amenable to kicking off the balance sheet reduction process after the next hike, though after two more "would be preferable."

He additionally floated the idea that the FOMC adjust the monthly pace as the process progresses.

The Fed could put in place "a moderate pace for stopping reinvestment that could involve things like caps," he said.

"We can slow or stop the pace depending on how market reacts," he said. "We just have to be cautious" and "be willing to adjust if things change."

–MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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