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.
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.