Balance Sheet Wind Down Good, But Not Simple

FOMC, balance sheet, ioer, selgin, lacey, federal reserve
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FOMC, balance sheet, ioer, selgin, lacey, federal reserveToday the Federal Reserve is set to announce the schedule for unwinding its balance sheet. This is a step in the right direction, but it also has the potential to increase the risk of a recession.

It’s past time to reduce the Fed’s balance sheet because its role in the economy is unnecessarily large. But without adding a strategy to eliminate the Fed’s interest payments on excess reserves that discourage bank lending, the Fed risks tightening monetary policy to the point where at best it makes it even harder for the Fed to hit its inflation target – and at worst risks another recession. Ultimately, the Fed must unwind its balance sheet in combination with ending interest on excess reserves in order to put the economy on a more solid monetary foundation.

George Selgin has been writing about the problem extensively in these pages and elsewhere. In particular, see his article "On Shrinking the Fed's Balance Sheet," and his American Banker piece with Norbert Michel on the Fed’s precarious balance sheet situation.

Watching the Fed's announcement closely? The press release will appear here. And Yellen's press conference can be viewed here.

  • M. Camp

    "…and at worst risks another recession."

    There's an implicit assumption in that sentence: a recession right now would be a bad thing. Of course we have no way of knowing who would benefit or suffer, or when, or in what way, or how much. We also have no way of aggregating benefits and harm to different people at different times into a statement "it was a bad thing" or "it was a good thing".

    Recessions reveal and eliminate some malinvestment, but even that benefit can't be evaluated or quantified, or assigned to known persons or time periods.

    We all fall into this error, I think, because the pain of a recession is "the Seen" and the benefits are the Unseen.

  • In the final analysis it matters not, for the population as a whole, whether the Fed does, or does not, reduce their balance sheet. If we were to assume otherwise, we must necessarily concede that by pushing buttons in Washington, DC, the Fed can increase the wealth of the nation. Of course, it cannot. The Fed can only make the economy and total wealth less worse than it would be under a regime of private money and free banking. The Fed is like a doctor attempting to maintain quality of life for their patient whose body is ravaged by cancer. Cancer the doctor injected in to patient to begin with. Thanks doc!

    Their pending decision could, on the other hand, dramatically alter who the winners and losers will be moving forward. Let's be very clear here. The Fed has damaged a lot of people in the process of helping relatively few since inception and, more relevant, in recent times. Given that the Fed has previously been willing to sacrifice the financial well being and lives of dollar holders, in the form of FR notes or bank deposits, and wage earners in favor of their member banks, pensioners, stock and bond holders, etc., the only question we should be asking is, will that change? I may be too presumptuous, but my guess is that it will not, and as soon as markets begin to react negatively to whatever policy they enact, and against the privileged groups, they will alter their course swiftly and without mercy.

    LET THEM EAT CAKE!

    • Ray Lopez

      @miltonchurchill:disqus -"In the final analysis it matters not, for the population as a whole,
      whether the Fed does, or does not, reduce their balance sheet. If we
      were to assume otherwise, we must necessarily concede that by pushing
      buttons in Washington, DC, the Fed can increase the wealth of the nation…" – hey Milton I'm pleased to see that you agree with my position that 'money is neutral' (has no real effect). Welcome to the club!

  • c141nav

    If the Fed dumps $4 Trillion dollars on the market, it will send the market down, right? America's pension managers are collectively under-invested by $4 Trillion dollars. Solution: The Fed gives — yes, literally gives — the money to American pension funds. The 'wealth effect' helps the middle class worker for a change.

    • No, no, no… not everyone has a pension. The Fed helps ONLY the middle class, in many cases upper middle class, workers who were employed by a state or the federal government or was in a state-privileged union.

  • Hu McCulloch

    I like the lead illustration of the tape worm that has infected the Fed's balance sheet ever since 2008!

  • Ray Lopez

    Author: "Today the Federal Reserve is set to announce the schedule for unwinding its balance sheet. This is a step in the right direction, but it also has the potential to increase the risk of a recession." – alarmist, as money is largely neutral, but see also this: How was the Quantitative Easing Program of the 1930s Unwound? Matthew Jaremski, Gabriel Mathy, NBER Working Paper No. 23788 Issued in September 2017 NBER Program(s): DAE
    ("Outside of the recent past, excess reserves have only concerned policymakers in one other period: the Great Depression. The data show that excess reserves in the 1930s were never actively unwound through a reduction in the monetary base. Nominal economic growth swelled required reserves while an exogenous reduction in monetary gold inflows due to war embargoes in Europe allowed excess reserves to naturally decline towards zero. Excess reserves fell rapidly in early 1941 and would have unwound fully even without the entry of the United States into World War II. As such, policy tightening was at no point necessary and could have contributed to the 1937-1938 Recession.")

    • George Selgin

      "While an exogenous reduction in monetary gold inflows due to war
      embargoes in Europe allowed excess reserves to naturally decline towards zero." Indeed; that, of course, isn't something we can count on to reduce the Fed's balance sheet these days.

      The "risk of recession" isn't in any case a risk posed by unwinding alone. Rather the risk comes from the combination of unwinding and the Fed's plan to continue raising its IOER ("fed funds") rate, with a projected increase of about 175 basis points w/in the next two years.

  • Mattyoung

    So, this great $2.4 Trillion investment by Congress is revealed. Will the anti-gravity machine work?

  • Fed Up

    "But without adding a strategy to eliminate the Fed’s interest payments on excess reserves that discourage bank lending"

    How do you define bank lending?

  • Seth Levine

    I have a technical question for you experts: Will a bank's ability to hold excess reserves shrink along with the Fed's balance sheet? Asked differently, will shrinking the SOMA portfolio require banks to replace excess reserves assets with different ones? Thanks!

    • Hu McCulloch

      Shrinking the Fed's balance sheet by unwinding QE I-III will sop up excess reserves, just as QE I-III was financed by creating new excess reserves. IMHO, eliminating Interest on Excess Reserves (IOER) should go hand in hand with unwinding the QE I-III base explosion, since excess reserves with a clear opportunity cost relative to lending are inflationary.
      See my Sept. 9 post here, "The Rudderless Fed".

      • Seth Levine

        Hello Hu, thanks for responding. I wholeheartedly agree with you on IOER. It's "free money" and IMHO offers banks a very attractive risk-adjusted return (which only increases as rates rise). What I am trying to understand is if the SOMA runoff will force banks to hold less excess reserves (i.e. they will no longer LEGALLY/TECHNICALLY have as much access to them) and hence will have to find another home for that capital, be it increased lending (inflationary) or security purchases. I am not familiar with the mechanism that "gaits" the maximum amount of excess reserves that a bank is allowed to hold (why not all of its capital?), so any information or direction to other sources would be greatly appreciated. Thanks!

        • Fed Up

          "What I am trying to understand is if the SOMA runoff will force banks to hold less excess reserves (i.e. they will no longer LEGALLY/TECHNICALLY have as much access to them) and hence will have to find another home for that capital,"

          Seth, at first glance I am not getting that part. Can you rephrase it for me? Thanks!

          • Seth Levine

            Sure thing (and I very much appreciate your time!). Ultimately, what I'm trying to figure out is: MUST excess reserves shrink (not, might they)? So I think I get that the Fed financed the QEs by creating reserves (bank sells bond to Fed, Fed credits bank's account). As bonds mature, the Treasury will pay the Fed (principal repayment). Will the Fed now go and debit those same bank accounts that were credited in the QE expansion? And if that is in fact the case, why couldn't a bank move cash (either from its own balance sheet or sell a security) back to its excess reserve account at the Fed to earn IOER if it deemed that to be a better use of capital than, say lending or security purchases?

          • Fed Up

            Seth, let me start by asking what is the capital requirement for a (central bank) reserve.