Federal Reserve officials have a difficult case to make when it comes to unwinding their enormous bond portfolio: arguing that a crisis-era tool they say was highly effective won't have much impact when removed.In response to the deepest recession in generations and a historic financial crisis, the US central bank brought interest rates down to zero in December 2008. At that point, the only major way to provide a further boost to a deeply damaged economy was to purchase trillions in government and mortgage bonds, a way to keep long-term borrowing costs down and support lending, investment and consumption.
While the economic recovery was slow and halting, the policies were largely successful in preventing a much worse outcome as US banks recovered much more quickly than their British and European counterparts. The expansion has also been the longest on record, and employment conditions, while still shy of pre-crisis norms, have improved considerably since the depths of the downturn, with the unemployment rate swooning from a 10% peak in October 2009 to its current 4.5%.
Now, the Fed is faced with the prospect of abandoning a policy whereby it ceases to reinvest the proceeds from maturing government bonds back into its asset portfolio which, at $4.5 trillion, is some five times larger than pre-recession norms.
But here's the rub, as described by economists at Deutsche Bank in a research note: what goes up, must come down.
"The challenge for the Fed is that the tapering of its balance sheet is likely to induce financial tightening, essentially reversing some of the allegedly positive effects of quantitative easing (QE)," the economists, led by Joseph LaVorgna, write. "However, the extent of this tightening is highly uncertain because QE was an unprecedented policy experiment."
This means the Fed's decision to announce the start of a reduction of its balance sheet, now expected around December, is forcing Wall Street forecasters to shuffle around their expectations for interest rate hikes. In other words, economists see the announcement of balance sheet reduction itself as basically equivalent to a rate increase. Imagine when the asset base actually starts shrinking.
Minutes of the Fed's March meeting made clear the central bank is planning some announcement later in the year, causing Jeremy Lawson, chief economist at Standard Life Investments, and his team to revise their rate forecasts to account for one meeting where that announcement will take place.
"As long as the labor market continues to improve, we expect the target range for the federal funds rate to be increased by 25 basis points in both June and September," Lawson wrote. "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."
Standard Life Investments
The economics team at Deutsche agrees.
"This recent Fedspeak is consistent with our forecast that the Fed will raise rates two more times this year, in June and September, before taking a pause in December to announce the run down of its balance sheet," LaVorgna and his colleagues argue.
"The taper is expected to begin in next year. Barring an economic downturn, we expect the Fed to adhere to its objective of running the balance sheet down in a highly predictable manner, using the fed funds rate as its primary policy tool," LaVorgna continued. "Nonetheless, the pace of adjustment of the fed funds rate will likely be affected by the tightening effects of balance sheet normalization."
The Fed is keen to avoid a repeat of a 2013 episode known as the "taper tantrum," when Treasury bond yields jumped sharply on a mere hint from then Fed Chairman Ben Bernanke that the central bank was about to start reducing the volume of its monthly asset buys.
Getting it right this time around will be easier said than done.