Ten years ago, before the collapse of Lehman Brothers rocked global financial markets, the Fed’s balance sheet stood at $925 billion—mostly U.S. Treasuries. After fifty-nine months of asset purchases to push down longer-term interest rates, it had ballooned to a peak of $4.5 trillion, including nearly $1.8 trillion in mortgage securities, in October 2014.
In October of this year, the Fed at last began a slow slimming-down of the balance sheet, allowing $10 billion in maturing securities to roll off without reinvesting the proceeds. All else being equal, this represents a tightening of monetary policy, as it tends to push up longer-term (10-year) market interest rates.
In Fed chair Janet Yellen’s words, the central bank “does not have any experience in calibrating the pace and composition of asset redemptions and sales to actual prospective economic conditions.” She has therefore stressed that the Fed sees its balance-sheet reduction as a primarily technical exercise separate from the pursuit of its monetary policy goals—in particular, pushing inflation back up to 2%. The Fed’s main tool for tightening monetary policy in a recovering economy would, therefore, she explained, be raising short-term market interest rates by paying banks greater interest on reserves (IOR). Since December 2015, the Fed has raised the rate on IOR by 100 basis points (1%), which has pushed up its short-term benchmark rate—the effective federal funds rate—in tandem.
But is Yellen right that the Fed’s gradual approach to balance-sheet reduction makes it relatively unimportant in its impact on monetary conditions? Our analysis suggests that it will be, in fact, considerably more important than the market, or the Fed itself, realizes. Here is why.
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