Fed's Balance Sheet Runoff Will End, but ECB Isn't Finished
We're all faced with a series of balancing acts. Trade-offs confronting us include labor vs. leisure, saving vs. spending, and calories vs. calisthenics. These calibrations have been taken to new depths of detail by an explosion of data and apps that analyze it. "Smart" watches can now nag you to relax, rebalance your portfolio and restrain your appetite.
Central banks also face a balancing act as they try to modulate growth and inflation. During the last decade, that balancing act has centered on balance sheets, as quantitative easing (QE) programs have gained prominence. Because there is no history that conclusively illustrates the effects of QE on economic outcomes, calibrating monetary policy is more difficult in this realm.
At the Federal Reserve's meeting next week, it is expected to announce changes to its balance sheet strategy. While esoteric to some, this topic has been top-of-mind for the financial markets. Handling its balance sheet well, and communicating strategy effectively, will be among the Fed's biggest tasks this year.
The Fed's balance sheet used to be pretty boring. It was small, and grew slowly over time in concert with the American economy. That changed when crisis-era programs and quantitative easing were implemented. By the beginning of 2014, the Fed's balance sheet was five times larger than it had been in 2008.
Under QE, the Fed purchased Treasury and mortgage-backed securities in an effort to bring down long-term interest rates. In so doing, they sought to make it costly for investors to become too risk-averse.
QE was a departure for the Fed, which is reluctant to own too many government securities. It gives the appearance of monetizing deficits, which runs counter to Fed independence. The separation of the Fed from the Department of the Treasury was formalized more than 60 years ago.
Studies of the effectiveness of QE in the United States have produced mixed results. As you might imagine, the need to control for the multitude of factors that affect interest rates makes isolating the impact of the program tricky. In aggregate, the program is estimated to have lowered long-term interest rates by about 1.5%, but successive phases of the effort are thought to have had diminishing influence.
In 2014, the Fed stopped adding to the balance sheet, confident in the durability of the U.S. economic expansion. And in the middle of 2017, plans for reducing the balance sheet were announced.