By Howard Schneider, Ann Saphir and Jonnelle Marte
(Reuters) – Stop with the “50 Bs.” Start with the 60.
The U.S. Federal Reserve’s quick pivot from shrinking its balance sheet by around $50 billion per month to now expanding by $60 billion monthly, has shown both the difficulty the Fed has faced under a shifting political environment, as well as the risks of experimenting with market-sensitive systems in real time.
The process of paring the balance sheet from its crisis-era levels of more than $4 trillion in assets, effectively “unwinding” some of the stimulus put in place to battle the worst financial crisis in a century, was agonized over for years by policymakers who were under sometimes intense pressure from Republicans on Capitol Hill who wanted a smaller central bank not so deeply engrained in private markets.
The careful shedding of $50 billion a month was lauded by those lawmakers as the Fed rolled it out in 2017, and was intended, as former Chair Janet Yellen said, to be so boring and non-disruptive it would be “like watching paint dry.”
And so it was, until President Donald Trump took notice near the end of his second year in office, chucked standing Republican concerns over the size of the Fed’s asset holdings, and criticized central bankers for doing what leading members of his party had demanded.
“Stop with the 50 B’s,” Trump tweeted in December.
Far from the traditional GOP concerns over “easy money,” Trump felt the Fed’s withdrawal from bond and mortgage markets was adding even more of an economic drag beyond what were then ongoing rate hikes.
By July, the $50 billion monthly rundown had ended. Two months later, the Fed confronted a new problem, one which had nothing to do with Trump and everything to do with its new system for managing interest rates.
That system depended on the Fed knowing roughly how much banks would demand in deposits at the central bank, which financial institutions may want to hold for a variety of reasons.
PAINTED INTO A CORNER?
But as time passed, Fed officials realized they weren’t sure quite what the demand would be and would have to feel their way.
Last month, Yellen’s paint-drying exercise was upended, and raised questions about how prepared the Fed was to manage a central bit of its business – ensuring adequate liquidity in financial markets.
“I’ve been really surprised at the struggle the Fed has had getting overnight rates to where they want them to be,” Northern Trust (NASDAQ:) economist Carl Tannenbaum said. “The Fed has had a hell of time” steering overnight rates to the midpoint of its target range of 1.75% to 2.00%.
Part of the problem, he said, is that the Fed was so intent on shrinking the balance sheet on “autopilot” that it “probably pushed the balance sheet reduction further than it should have done.”
But the fact that reserves were becoming scarce, Tannenbaum said, should have been obvious.
To Tannenbaum, the new operation should definitely be considered under the umbrella of monetary policy. “Monetary policy is implemented with a combination of steps,” he explained. “The steps taken recently by the Fed are part of monetary policy, and have to be considered that.”
Not so, said Dallas Fed President Robert Kaplan.
“It is not intended to create more accommodation or create more stimulus,” told reporters after a talk at the Commonwealth Club in San Francisco. “This is not intended to have any impact on monetary policy. It’s not designed that way.”
The two interest rate reductions passed by the Fed this year have also been characterized as “insurance cuts” meant to extend the recovery and protect an economy that is in a “good place.”
But regardless of the intention, the steps taken this year to reduce rates and now to expand the balance sheet may amount to an unwinding of the monetary policy adjustments made last year, some investors say. If the Fed reduces interest rates twice more this year, it would completely undo the four interest rate hikes passed in 2018.
“It’s effectively quantitative easing. Investors should look at this as yes, a complete reversal of Fed policy from a year ago,” said Chad Morganlander, senior portfolio manager at Washington Crossing Advisors in Florham Park, New Jersey. “It confirms to investors that the Fed has their back. They’ll do whatever it takes to keep the U.S. financial system calm.”
Powell and other policymakers stress that the messaging is important. The Fed chair said Tuesday that the balance sheet expansion “should in no way be confused” with the asset purchases made during the financial crisis.
Minneapolis Federal Reserve Bank President Neel Kashkari echoed that message in New York Friday morning. He said that the central bank would be operating with a large balance sheet “for the foreseeable future.”
And he was careful to point out that purchases of short-term Treasury bills are different from purchases of long-term bonds.
“QE was designed to also move long rates by us buying long- term assets,” he said. “If the Fed is buying short-term bills just to provide liquidity to the system, there is nothing QE about that.”