Quantitative Easing

Shrinking the Fed’s balance sheet is unlikely to be a benign process, new Jackson Hole study warns

If the past repeats itself, central bank balance sheet reduction is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s on- and off-balance sheet liabilities.


— Raghuram Rajan, former Governor of the Reserve Bank of India and former Chief Economist of the IMF

The Federal Reserve wants to be able to shrink its balance sheet in the background 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 shrinkage is unlikely to be an entirely benign process,” according to the study. Shrinking the balance sheet is “a daunting task”, concludes the article by Raghuram Rajan, former governor of the Reserve Bank of India and former chief economist of the IMF and other researchers.

Since March 2020, at the start of the coronavirus pandemic, the Fed 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. economy and the housing market.

The Fed stopped buying assets in March and implemented a process to gradually reduce the portfolio. Officials see it as another form of monetary policy tightening that will help reduce inflation while raising interest rates.

The Fed began trimming its balance sheet in June and is accelerating next month to hit its peak rate of $95 billion a month. This will be accomplished by letting $60 billion in treasury bills and $35 billion in mortgage-backed securities leave the balance sheet without reinvestment.

This pace could shrink the balance sheet by $1 trillion a year.

Fed Chairman Jerome Powell said in July that balance sheet reduction could continue for “two and a half years.”

According to the study, the problem is how commercial banks react to the policy tool of the Fed.

When the Fed buys securities as part of quantitative easing, commercial banks keep the reserves on their balance sheets. They finance these reserves by borrowing from hedge funds and other shadow banks.

The researchers found that commercial banks do not reduce such borrowing once the Fed begins to reduce its balance sheet.

This means that as the Fed’s balance sheet shrinks, there are fewer reserves available to repay these loans which are often in the form of large and highly “executable” demand deposits, Rajan said, in a interview with MarketWatch on the shelving of the Jackson Hole. Meet.

During the last episode of quantitative tightening, the Fed had to reserve its course and flood the market with liquidity in September 2019 and then in March 2020.

“If the past repeats itself, central bank balance sheet reduction is unlikely to be an entirely benign process and will require careful monitoring of the banking sector’s liabilities on and off balance sheet,” the document said.

Partly in response to earlier crisis episodes, the Fed introduced a permanent repo facility to allow primary dealers, the major financial institutions that buy government debt, to borrow more reserves from the Fed against high quality guarantees.

Rajan said this emergency funding “may not be broad enough to reach everyone who is cash-strapped.”

The document notes that some banks, which have access to cash, might try to hoard it in times of crisis.

“The Fed will then have no choice but to step in again and lend broadly as it did in September 2019 and March 2020,” the paper said.

This could complicate the Fed’s plans to raise interest rates to tame inflation.

More fundamentally, researchers raise questions about the effectiveness of the opposite policy – ​​quantitative easing – as a useful tool for monetary policy. Quantitative easing was used by the Fed to provide liquidity and support financial markets during the coronavirus pandemic in 2020.

Fed officials often justify QE by saying it lowers long-term interest rates and allows more borrowing, but economists said evidence for this is sparse.

Former Fed Chairman Ben Bernanke once joked that quantitative easing works in practice but not in theory.

The paper released in Jackson Hole argues that real evidence that banks did not increase borrowing from business customers during quantitative easing, but preferred to lend to hedge funds and other businesses.

Instead of QE, central banks in Europe and Japan have moved to directly buying stocks and corporate bonds and funding them efficiently.

It may be appropriate for the Fed to appeal to fiscal authorities to support activity “since pushing the chain of quantitative easing when economic transmission is muted can only increase potential financial fragility and the likelihood of financial strains” .