Issue of the week: The Fed’s great shrinking act
The Federal Reserve is “going on the financial equivalent of a diet,” said Heather Long in The Washington Post. Nearly a decade after the central bank began a bondbuying spree to stabilize the economy after the 2008 financial crisis, it’s ready to slim down—announcing last week that it will begin reducing its $4.5 trillion portfolio of government and mortgage debt. Many economists credit the Fed’s massive bond purchases, alongside its slashing of interest rates to near zero, with helping to pull the U.S. out of the recession. Now the Fed is signaling that “it believes the economy has finally bounced back.” This move takes the Fed into “uncharted territory,” said Binyamin Appelbaum in The New York Times. Just as the magnitude of the central bank’s purchases after the 2008 crisis were unprecedented—it more than quadrupled its holdings, from $900 billion to an unheard-of $4.5 trillion—so is this retreat. The Fed has simply never tried to unwind such a massive balance sheet. “No one can be certain what will happen.”
That uncertainty is why Federal Reserve Board Chair Janet Yellen wants the shrinking to be “as boring as possible,” said Nick Timiraos in The Wall Street Journal. She has telegraphed for months that the central bank intends to start slowly at first, allowing $10 billion worth of Treasurys and mortgage-backed securities to “roll off” the balance sheet each month, meaning they will mature and the Fed won’t reinvest the proceeds. That figure will gradually ramp up to $50 billion a month in a year. Those signals are one reason why “markets haven’t blinked.” But there is still plenty of risk ahead. If the Fed moves too quickly, it could rattle stocks and imperil economic growth. And if the Fed moves too slowly, it could be left holding a bloated balance sheet when the next downturn hits, robbing it of the tools it used to respond to the 2008 crisis. No one knows how long the process will take, said Rich Miller in Bloomberg.com, because the Fed has purposely not indicated “how far it wants to go” in shrinking its holdings. In the meantime, analysts expect borrowing costs for mortgages and other loans to inch up, and for costs for “companies in China and other emerging markets that borrow in dollars” to increase. But the movement should be gradual, just like the Fed’s.
One wild-card factor: “The market still doesn’t know who will be leading the Fed a year from now,” said Paul La Monica in Money.com. Yellen’s four-year term ends in February, and she has refused to say “whether she’d agree to stick around for a second term if President Trump asked her to stay.” Trump has praised Yellen’s performance, but some other candidates he is reportedly considering want the Fed to scale back its holdings more aggressively. White House chief economic adviser Gary Cohn was widely tipped as the likely pick, said Hugh Daly in NBCNews.com, but he reportedly “rankled” Trump by criticizing the president’s response to Charlottesville. Whomever Trump nominates, the president can put a lasting stamp on the Fed for years to come: Four seats on the bank’s seven-member board need to be filled.