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Why the Fed shouldn’t scale back its balance sheet

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         Why the Fed shouldn’t scale back its balance sheet

Federal Reserve Chairwoman Yellen recently announced that the era of stimulative monetary policy is ending. The Fed has established expectations for about three quarter-point increases in the federal funds rate each year until it reaches about 3%. Policy makers have signaled their intention to begin shrinking the Fed balance sheet, as early as the end of this year.

Extended periods of low interest rates impose distortions on capital markets — for example, they encourage an excessively robust market for junk bonds and speculative activity in equity, real estate and commodity markets. And I have encouraged the Fed to also establish a schedule for raising the federal funds rate to modify investor expectations.

Inflation has reached the Fed target of 2%. Although the headline unemployment rate is 4.5% and wage pressures are building, some 7 million men between the ages of 25 and 54 are neither working nor seeking employment.

Shadow unemployment has roots in a mismatch between skills and the requirements of a globalized economy, chronic trade deficits in manufacturing, and the expansion of entitlements — such as expanded access to virtually free health care through Medicaid.

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A decade of stimulative monetary policies has failed to deliver growth above 2% owing to those and other structural problems that Fed policy cannot address. However, regarding structural issues more within the Fed’s specific influence — bank regulatory policies — its regulatory chief, Daniel Tarullo, has been largely indifferent to excesses in the implementation of Dodd-Frank.

Examples include the burdens of regulatory compliance that have made business lending unnecessarily difficult for regional banks and certain capital requirements that impose no guardrail but curtail lending by major banks.

The bias at the Fed seems to be to act as if structural problems are of minor consequence, and that it can continue to make policy as if we lived in the days before Alan Greenspan.

Emerging plans to scale down the Fed balance sheet are a case in point.

Prior to the financial crisis, assets on the Fed’s books totaled about $950 billion — mostly Treasury securities and some commercial paper. With the advent of quantitative easing, those grew to $4.5 trillion with substantial purchases of mortgage-backed securities (MBS) and additional Treasuries. While some reduction of these holdings might now be in order, fundamental changes in the structure of the mortgage market and Fed activities argue against this.

The combination of Dodd-Frank and the federalization of Fannie Mae and other government-sponsored banks greatly limit the availability of conventional direct bank mortgage financing to low and middle income families. Even more than in the past, banks are inclined to act only as brokers for government-sponsored banks. Although members of Congress and the Obama administration expressed interest in getting the government out of the mortgage business, a solution has not emerged.

MBS constitute about $1.8 trillion of the Fed’s holdings, and those pose particular risk for ordinary fixed-income investors — repayment schedules vary with labor-market conditions (incentives to relocate) and refinancing opportunities — and MBS are structured securities, which recent history indicates are subject to abuses individual investors are want to detect.

Whittling down the Fed’s Treasury holdings of $2.5 trillion would have similar, albeit indirect effects on mortgage interest rates. The conventional 30-year fixed rate already stands at about 4.2% and is well above expected inflation to yield a nice real return.

Overall, scaling back Fed holdings of MBS and Treasuries would likely push up mortgage rates too much and put at risk new home construction. In an environment where other engines of economic expansion are uninspiring — namely, auto purchases and broader consumer spending — such actions would make the continued recovery terribly dependent on the new petroleum development boom and prospects for a Trump tax cut and infrastructure program, which are becoming less certain.

Additionally, the Fed is now offering interest-paying deposits to money markets, asset managers, hedge funds and the like. Coupled with the growing demand for dollars worldwide, the current required asset position of the Fed is in excess of $2.5 trillion and that will likely grow to more than $4 trillion over the next decade, Ben Bernanke estimates.

It would simply be better to continuing to increase the federal funds rate and stand pat on the balance sheet.

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