• The Fed Contemplates the Great Reduction

In a recent meeting here at the bank, two of my partners were celebrating their success at losing weight. One relied primarily on fitness, while the other followed a strict diet. Both agreed, though, that reduction was more difficult than accumulation.

The Federal Reserve, which meets again next week, finds itself contemplating a similar transition. Having accumulated a massive portfolio of securities during its quantitative easing (QE) program, the Fed has now arrived at a point where reduction is appropriate. But trimming the weight of monetary accommodation may not be easy.

When short-term interest rates were lowered to near-zero at the end of 2008, the Federal Reserve and other global central banks turned to unconventional strategies. Both the Fed and the Bank of England aggressively took up QE, and the European Central Bank and the Bank of Japan followed suit somewhat later. The Fed is the first of the bunch to seriously consider unwinding these efforts.

QE operates through several channels. Purchasing long-term securities lowers long-term rates, which aids sectors of the economy that depend on longer-term credit. By reducing the yield on risk-free assets, QE raises the cost of risk aversion and invites capital to become more aggressive. In combination with forward guidance, QE also reinforces the message to markets that the central bank is intent on doing whatever it takes.

QE was hotly debated in each of the markets in which it was applied. From a historical perspective, the U.S. Fed was once responsible for supporting liquidity in government bond markets, a linkage that was broken in the 1950s to establish the independence of monetary and fiscal policy. The large-scale asset purchases that began in 2008 were seen in some corners as backtracking on that accord, and as a step toward monetizing debt.

When mortgage-backed securities (MBS) were added to the QE mix, some complained the Fed was favoring the housing industry over others. Central bank investment programs have affected pricing and liquidity in the markets where they have concentrated their holdings. For a multitude of reasons, former Richmond Fed President Jeffrey Lacker expressed concern that QE placed the Fed’s reputation at risk, and urged an early end to the program. (Ironically, Lacker was forced to step down from his post earlier this year after admitting to an ethical lapse.)

There are certainly differences of opinion over how effective QE has been. As a whole, however, it is fair to say that the Fed’s aggressive strategy is one reason why the American economy has enjoyed an eight-year recovery. This outcome has diminished the need for easy money, and the Fed has set about slowly getting back to normal.

Designing a program to skinny down the Fed’s balance sheet will require exploration of the following topics.

Setting a Goal

Defining the new normal when it comes to the Fed’s balance sheet isn’t easy. At first blush, one might ask why asset holdings shouldn’t decline to where they stood prior to the financial crisis. The answer would be that neither banks nor the Fed want that outcome.