By Steven K. Beckner
Written exclusively for InTouch Capital Markets
24th July 2017
This article details a full discussion between Steven Beckner and Cleveland Fed President Mester around the timing of balance sheet reduction and rate hikes. The interview took place on Thursday 6th July, before the start of the pre meeting blackout period.
For Beckner’s views on how this fits into the overall view on the FOMC heading into the next meeting, see the separate article on the blog.
When I interviewed Cleveland Fed President Mester, she said there is nothing to prevent the Fed from starting to reduce the balance sheet at the same time that it raises rates again since the balance sheet reduction strategy is so gradual and unlikely to have a big impact on rates.
“The main policy tool we have right now is the funds rate…,” she explained. “So when I’m thinking about policy, that’s the tool I’m thinking about calibrating so we can maintain a sustainable expansion.”
“The balance sheet, when we went in to do the various asset purchase plans, we knew that at some point the economy would recover, would be strong enough that we would have to take that accommodation out,” Mester continued. “So the plan for reducing the amount of reinvestment … is basically one that says, ‘okay let’s start bringing the balance sheet back to a more normal level and normalizing the composition of the balance sheet as well.'”
“Now that plan that we put out details of at the last FOMC meeting of course is a gradual plan,” Mester went on. “So there’s nothing in my mind that precludes us (from) initiating that AND doing something on the funds rate even at the same time.”
“So again I view the funds rate as our policy tool, and I view the plan for reduction of the balance sheet as something that can run in the background. It’s very gradual, you know, a sort of set-it-and-forget-it kind of thing, given where the economy is expected to head.”
“When I go into each meeting, I’ll determine where I want the funds rate and whether it’s time to initiate that balance sheet (plan)”
Mester said a decision to raise rates and start shrinking the balance sheet at the same time “is going to depend on where the economy is…. So you come in and you look at what the data is telling you and what your forecast is telling you.”
But she reiterated, “I don’t see anything that would preclude that.”
Mester emphasized the need for clear communication. “The key thing is that we’re trying to do this in a way … that it’s not viewed as a change in policy stance.”
She recalled that the 2013 “taper tantrum,” when bond yields spiked after former Fed Chairman hinted at curtailing asset purchases, occurred “because the public interpret(ed) that as the Fed has changed its view on policy.”
This time around, “we set this up in a gradual way, because we don’t want this, whenever it happens — the initiation of the balance sheet plan — (to be seen) as ‘Oh, the Fed has changed its view on policy.'”
Some Fed officials feel strongly that, for the sake of clear communicating with the market and clearly interpreting market reactions, it would be best to raise rates and start balance sheet reduction separately, at least in the beginning.
But Mester said “if the data coming in are suggesting it’s time for another rate increase, I don’t see why that would preclude us on the balance sheet.”
On the other hand, if the data is weaker than the forecast, “we might not do the funds rate but we could do the balance sheet,” she said.
“So I don’t think it’s easy to read how things are going to be interpreted, but the key thing is we’re going to be setting our funds rate, our primary policy tool, consistent with our view of the medium run outlook for the economy,” Mester said. “And the balance sheet initiation plan we want basically to happen in a way that’s not disruptive to the financial markets, that’s well understood, is well-telegraphed.”
“Whether they happen at the same time or not is really dependent on how the economy is faring, what the data is telling us about the outlook,” she added.
As things now stand, Fed officials hope the market reaction to the start of balance sheet reduction will be fairly mild. But, as Mester acknowledged, “it’s very hard to anticipate fully how the market will react.”
“I could very well imagine whenever we do initiate the plan there will be a market reaction probably,” she said. “But the real question is, is it long-lasting and does it affect the medium run outlook? And our hope is that by communicating well in advance and being as transparent as we can about what this change in reinvestment policy means — that it’s not a change in our outlook for policy, but it’s really a step on normalizing the balance sheet which we knew were going to have to do at some point that we won’t get that market reaction.”
Mester said the Fed will “have to be attuned to” the market reaction and “will deal with that when the time comes. But again it really is: does that then affect the medium run outlook and therefore necessitate a change in the policy path, and we’ll just have to wait and see how things develop.”
Mester is expecting a modest impact on the yield curve.
“This is such a gradual reduction in the balance sheet that I don’t anticipate that, if we do X on the balance sheet we’re going to change our path for (funds rate) policy to make up for it,” she said. “But the nice thing about it being as gradual …is that we’ll see.”
Mester allowed for the possibility that curbing reinvestments “could … have a bigger impact than I anticipate, and then we can adjust the path.”
But Mester said, “I don’t anticipate that, because it’s such a gradual reduction and most estimates I’ve seen suggest that, especially in a period where financial markets are working well, …. the sizes we’re talking about, … it won’t have a large effect on the market.”
“So think of the balance sheet (plan) as being in the background running its course to reduce the size of the balance sheet, and then the funds rate is going to be our tool of policy, and I don’t anticipate changing my funds rate path because of what we’re doing on the balance sheet.”
What if there were to be an adverse reaction to the start of balance sheet reduction? “It depends on what you mean by negative reaction in the market,” Mester replied. “A short-run reaction in the market that isn’t lasting, I don’t think that should necessitate a change in policy. The hope again is that we’ve communicated this well in advance and that market participants will understand that this is not a change in the policy trajectory in any sense; it’s not a change in our view about what appropriate policy is.”
Mester’s belief that the tightening effect of balance sheet reduction is likely to be modest is bolstered by research done at the Kansas City Federal Reserve Bank by director of research Troy Davig and economist A. Lee Smith. They find that “a $675 billion reduction in the Fed’s balance sheet over a two-year horizon is about equivalent to a 25 basis point hike in the funds rate.” Others foresee a somewhat larger effect, but not dramatically so.
To the extent this “modest” prospective impact is accepted by the FOMC as a whole, policymakers seem less likely to pull their punches on continued monetary firming.
Prior article by Steven Beckner for InTouch Capital Markets: FOMC Minutes May Show Just How Much Of a Split There Is On Inflation
Steven Beckner is a veteran financial journalist with four decades of experience of reporting on the Federal Reserve. Mr Beckner is the author of Back From The Brink: The Greenspan Years (Wiley, 1997) and can also be heard speaking regularly on National Public Radio.