“If the past repeats itself, central bank balance sheet shrinking is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s callable liabilities on the balance sheet and off balance sheet“
The Federal Reserve wants to be able to shrink its balance sheet on the back burner with little fanfare, but that may be wishful thinking, according to new research presented at the Fed’s summer conference in Jackson Hole on Saturday.
“If the past repeats itself, central bank balance sheet shrinking is unlikely to be an entirely benign process,” according to the study. Shrinking the balance sheet is a “tough task,” concludes the report by Raghuram Rajan, a former governor of India’s central bank and former chief economist of the IMF and other researchers.
Since March 2020, at the start of the coronavirus pandemic, the Federal Reserve has doubled its balance sheet to $8.8 trillion by buying Treasuries and mortgage-backed securities to keep interest rates low to support the economy and the housing market.
The Fed stopped buying assets in March and set in motion a gradual shrinking of the portfolio. Officials see this as another form of monetary tightening that will help reduce inflation along with higher interest rates.
The Federal Reserve began shrinking its balance sheet in June and will increase it next month to its maximum rate of $95 billion a month. This would be accomplished by allowing $60 billion in Treasuries and $35 billion in mortgage-backed securities to be withdrawn from the balance sheet without reinvestment.
That rate could reduce the balance sheet by $1 trillion a year.
Fed Chairman Jerome Powell said in July that the balance sheet reduction could last “two and a half years.”
The problem, according to the study, is how commercial banks respond to the Fed’s policy tool.
When the Fed buys securities under quantitative easing, commercial banks hold the reserves on their balance sheets. They finance these reserves through loans from hedge funds and other shadow banks.
The researchers found that commercial banks did not reduce these loans after the Fed began shrinking its balance sheet.
That means as the Fed’s balance sheet shrinks, there are fewer reserves available to repay those loans, which are often in the form of wholesale deposits and are very “liquid,” Rajan told MarketWatch in an interview on the sidelines of the Jackson Hole meeting .
During the last episode of quantitative tightening, the Fed had to stay on course and flood the market with liquidity in September 2019 and again in March 2020.
“If the past repeats itself, shrinking the central bank’s balance sheet is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s callable liabilities on the balance sheet and off-balance sheet,” the paper said.
Partly in response to previous episodes of stress, the Fed created a permanent repo facility to allow primary dealers, the key financial institutions that buy government debt, to borrow more of the Fed’s reserves against high-quality collateral.
Rajan said this emergency funding “may not be broad enough to reach all the people who don’t have liquidity”.
The paper notes that some banks that have access to liquidity may try to hoard it in times of stress.
“Then the Fed will have no choice but to step in again and lend heavily, as it did in September 2019 and March 2020,” the paper said.
That could complicate the Fed’s plans to raise interest rates to bring inflation under control.
More fundamentally, researchers are raising questions about the effectiveness of the opposite policy—quantitative easing—as a useful monetary policy tool. Quantitative easing was used by the Fed to provide liquidity and support financial markets during the 2020 coronavirus pandemic.
Fed officials often justify QE by saying it lowers long-term interest rates and allows more borrowing, but economists say the evidence for this is scant.
Former Fed Chairman Ben Bernanke once said that quantitative easing works in practice, but not in theory.
The paper, published in Jackson Hole, argued that the actual evidence was that banks did not increase lending to commercial customers during quantitative easing, but instead gave loans to hedge funds and other firms.
Instead of QE, central banks in Europe and Japan switched to directly buying stocks and bonds of corporations and financing them effectively.
Perhaps it is appropriate for the Fed to call on fiscal authorities to support activity, “as pushing the thread of quantitative easing when economic transmission is muted can only increase potential financial volatility and the likelihood of financial stress.”