Should US Fed start debate on balance sheet?

A worker building a pipe in Ohio in the United States. The outlook for the country's economy has brightened. Also, President Donald Trump has put expansionary fiscal policy on the horizon. If fiscal stimulus begins to overheat the economy, the US Fed
A worker building a pipe in Ohio in the United States. The outlook for the country's economy has brightened. Also, President Donald Trump has put expansionary fiscal policy on the horizon. If fiscal stimulus begins to overheat the economy, the US Fed might tighten policy more sharply.PHOTO: AGENCE FRANCE-PRESSE

WASHINGTON • It is time to talk about the balance sheet.

Eight years after the United States Federal Reserve launched the first of three controversial bond-buying campaigns to help save the US economy, its holdings are stuck at US$4.5 trillion (S$6.4 trillion) and the question of when to let them shrink is beginning to simmer.

Several policymakers have pushed publicly to get the debate started. How the discussion plays out could have big implications for the pace of future interest rate hikes and for the dollar.

"They should start framing this for the market," said Mr Michael Gapen, chief US economist at Barclays. Investors need to hear what the "balance of policy" will be between the balance sheet and the central bank's main tool, the federal funds rate, he added.

The sheer weight of the balance sheet helps hold down long-term US borrowing costs, which is why the Fed bought bonds in the first place. If officials allow holdings to mature without continuing their current practice of reinvesting the principal, they could push yields higher by reducing demand in the bond market.

The topic has shot to renewed prominence as the outlook for the US economy has brightened. The Fed has raised rates twice in the last 13 months and pencilled in three quarter-point moves this year. Moreover, newly inaugurated President Donald Trump has put expansionary fiscal policy on the horizon.

If fiscal stimulus begins to overheat the economy, the Fed might tighten policy more sharply.

St Louis Fed President James Bullard said he would prefer to use the balance sheet to do some of that lifting, echoing remarks by his Boston colleague Eric Rosengren.

"If you think the economy is growing more rapidly then you want, you can either continue to raise short-term rates, or you can also do balance sheet in conjunction with that," Mr Rosengren said in a Jan 9 interview.

At the very least, he added, the Fed should be talking about the issue soon. San Francisco Fed president John Williams, Atlanta's Dennis Lockhart, Philadelphia's Patrick Harker and Dallas chief Robert Kaplan have all agreed.

None of them has expressed urgency and the topic may not be on the agenda when the Federal Open Market Committee (FOMC) convenes again on Tuesday.

But each knows it can take the FOMC several meetings to make big decisions and they are likely eyeing where rates will be a year from now. Mr Rosengren is thought by Fed watchers to favour four hikes this year.

"I don't think it's something they'll do in 2017," said Mr Mark Zandi, the chief economist at Moody's Analytics. "My guess is they view this as a 2018 project."

Even if they do not make changes to the balance sheet this year, current policymakers may be keen to hammer out their strategy for another reason: Mr Trump is expected to appoint a new leader at the Fed when Dr Janet Yellen's term as chair expires in February next year.

"That individual might want to undo what has been done in a fashion that could be disruptive to both the financial markets and the economy," economist Raymond Stone, of Stone & McCarthy Research Associates in Princeton, wrote in a Jan 19 note to clients.

That "argues for the FOMC to at least have a plan in place, which is understood by the markets as well as the public, before Dr Yellen's term ends".

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A version of this article appeared in the print edition of The Straits Times on January 25, 2017, with the headline 'Should US Fed start debate on balance sheet?'. Print Edition | Subscribe