Edging toward normality
25 April 2017
Although the communication materials released immediately after the March Federal Open Market Committee meeting made no mention of the Federal Reserve’s (Fed) policy of reinvesting the securities in its System Open Market Account portfolio having been discussed, the minutes revealed that an active debate had taken place. The key sentence was that if the “economy continued to perform about as expected, most participants anticipated that…a change to the Committee’s reinvestment policy would likely be appropriate later this year”. A final decision has not been made though, as officials are still debating the precise trigger, method and pace. Some members prefer reinvestments to be phased out, while others want them to end immediately. Some want the change to be data dependent; others prefer a date to be set in advance. However, all agreed that balance sheet reduction should be “gradual and predictable, and accomplished primarily by phasing out reinvestments of principal” rather than the outright sale of securities. The majority also prefer changes to the federal funds rate to be the main policy tool above the lower bound, leaving balance sheet runoff to be more mechanical.
In light of this information, we have updated our policy projections to incorporate a specific path for the Fed’s balance sheet as well as the federal funds rate. As long as the labour market continues to improve, we expect the target range for the federal funds rate to be increased by 25bps in both June and September. The Committee would then pause to announce the change in reinvestment policy in December, before resuming rate increases in March 2018, lifting rates three times that year. We think that reinvestments will initially be phased out through 2018 and 2019, with the Fed aiming for the Treasury portfolio to come down by around USD 20bn per month. With USD 414bn worth of Treasuries maturing next year and USD 352bn in (see Chart 1) phase-out has the advantage of not shrinking the balance sheet too quickly and implies that around USD 175bn of reinvestments in year one and USD 110bn in year two. Those reinvestments are likely to be aimed mainly at maintaining the current maturity profile of the portfolio but also smoothing future balance sheet runoff. Although MBS securities are not scheduled to begin maturing until 2027, some securities are likely to be prepaid and not reinvested by the Fed. Reinvestments would end completely in 2020. If we are right in this assessment, the size of the Fed’s balance sheet will decline from around 23% of GDP in 2017 to around 8% of GDP in 10 years’ time (see Chart 2) – only a little above the size that prevailed before the financial crisis.
There are, however, ‘shocks’ that could alter this outlook. Bond markets have absorbed prospective normalisation calmly so far, but the Fed will resist a repeat of 2013’s taper tantrum. The trajectory of bank lending and money supply growth will also be monitored for signs that the joint normalisation of the policy rate and balance sheet is unduly influencing financial conditions. A substantial easing of fiscal policy could also force a rethink, though the Fed would have to balance the need for tighter monetary conditions with the desire to avoid a surge in bond supply. Conversely, a recession would likely see it resume balance sheet expansion, though the rapidity of that response would depend on how far fed funds rate normalisation had proceeded.
Jeremy Lawson, Chief Economist