This week’s rate
cut hike has reignited the debate about the FOMC’s options going forward.
Earlier this year, as Trump and his economic spirit animal Peter Navarro attempted to jawbone the dollar lower, some began to ask whether it wouldn’t make more sense for the Fed to tighten with SOMA rolloff or even outright asset sales as opposed to going the traditional FF hike route.
The rationale sounds complicated, but it really isn’t. The idea is that letting the SOMA portfolio roll off will have less of an effect on short end rate differentials than outright rate hikes and thereby wouldn’t further underpin the case for a structurally strong dollar. Why does this matter? Well, because Donald Trump the FX strategist wants a weaker greenback and so the very same Fed which Trump accused of “doing political things” last September is now forced to think politically about how to tighten. This is exacerbated by the upcoming Fed reshuffle.
Make no mistake, you’ll be hearing quite a bit about this going forward and so, with that in mind, consider the following excerpts from a Goldman piece out Sunday.
The debate within the FOMC about balance sheet normalization is now underway. Fed officials have two basic choices. They can rely exclusively on the funds rate for now and leave balance sheet decisions to the new leadership team in 2018, or they can combine ongoing funds rate hikes with a turn to balance sheet runoff later this year.
The economic case for relying solely on the funds rate is that this instrument is better understood and that moving away from zero restores conventional easing capacity. The economic case for adding balance sheet normalization is reduced upward pressure on the dollar and arguably a lower risk of asset price bubbles.
None of these arguments, on either side, seem particularly powerful at the moment. Standard models suggest that modest balance sheet normalization should not have large FCI effects, the risk of another lower bound event has fallen, inflation is already close to the target, and the evidence for asset price bubbles is currently limited.
A more practical case for early balance sheet normalization is based on the upcoming Fed leadership transition. If the new appointments—especially the new Chair—are thought to favor aggressive balance sheet normalization, perhaps even including asset sales, and if all decisions are left up to the incoming team, financial markets might experience heightened uncertainty during the transition. 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.”
The current FOMC could reduce that uncertainty by establishing an early “baseline” path for very gradual balance sheet rundown. Committee decisions are subject to change, of course, but markets would probably take comfort from the fact that most FOMC members will remain in their positions and that it is harder for the new leadership to radically change a policy that is already in place than to devise a new one. We therefore expect the committee to announce gradual tapering of reinvestments in December 2017, while holding the funds rate unchanged at that meeting.
We now contrast two possible tightening scenarios. In the “early start, passive runoff” scenario, the Fed gradually tapers reinvestment in December 2017 over 10 months but does not sell assets. In the “late start, active sales” scenario, the Fed ends reinvestment in July 2018 without tapering and actively sells $40bn of assets per month. In the latter case, the balance sheet shrinks by about $250bn per quarter starting in 2018H2, with similar contributions from maturing assets and active sales (Exhibit 3, right panel).
For the “early start, passive runoff” scenario, we assume 3 hikes in 2017 and 4 in 2018 and in 2019, in line with our forecast. How much less does the funds rate have to rise in the “late start, active sales” scenario to deliver the same amount of total tightening as in the other scenario? Our baseline estimate is that a 25 basis points (bp) hike in the funds rate has the same growth effect as a $1,500bn decline in the Fed’s balance sheet, likely taking place over a few years (Exhibit 4, left panel). In other words, a $100bn rundown in the balance sheet is equivalent to a 1.5-2bp increase in the funds rate. Therefore, the “late start, active sales” scenario—which implies $500bn of additional balance sheet rundown in 2019— requires the funds rate to rise about 8bp less in 2019 (Exhibit 4, right panel).
While our baseline estimate suggests relatively little tightening from balance sheet rundown, the uncertainty is substantial. Our review of the empirical QE literature suggests a wide range of estimates; the largest implies that it only takes $250bn of balance sheet rundown to offset one funds rate hike. The 2013 “taper tantrum” also provides a reminder that the impact of balance sheet policy on financial conditions is uncertain and could be larger than our baseline estimate. We doubt the impact would be as large today—in 2013 markets misunderstood tapering as implying earlier rate hikes, whereas today markets would likely view earlier tapering as implying later hikes— but the risk is worth considering.