Before the 2008 collapse of Lehman Brothers, the Fed’s balance sheet stood at $925 billion—mostly U.S. Treasury securities. After 59 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 2014.
In October of 2017, the Fed at last began a slow slimming-down of its balance sheet, allowing a growing amount of maturing securities to roll off monthly without reinvesting the proceeds. In former Fed chair Janet Yellen’s words, the central bank did “not have any experience in calibrating the pace and composition of asset redemptions and sales to actual prospective economic conditions.” She therefore stressed that the Fed saw its balance-sheet reduction primarily as a 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 195 basis points (1.95%), which has pushed up its short-term benchmark rate—the effective federal funds rate—in tandem.
By historical standards, the Fed’s rate hikes have been cautious. Even with inflation on target and unemployment at historic lows, the Fed has been raising short rates more gradually than in any tightening period going back to the 1950s.
We believe, however, that rate hikes understate the degree of tightening the Fed has imposed over the past year. The reason is that the Fed appears to be underestimating the impact of its balance-sheet reduction. Here is why.
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