Fed’s Mester backs shrinking balance sheet ‘as fast as we can’ without pushing markets off track

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Cleveland Fed President Loretta Mester on Wednesday said she would like the central bank to shrink its balance sheet quickly so that it comes down to a “more reasonable size” as long as the pace doesn’t negatively impact financial markets.

During the COVID-19 pandemic and the disruptions in the Treasury market, the Fed bought securities. The central bank’s balance sheet doubled to $8.8 trillion.

With the Fed actively planning to move away from its ultra-easy policy stance adopted when the economy recoiled during the pandemic shutdown, shrinking the balance sheet and raising interest rates are on the table.

Financial markets are watching the debate on the balance sheet closely. Trader after trader have appeared on the cable business networks since 2020 saying the Fed’s asset purchases, sometimes called quantitative easing, has bolstered financial asset valuations. And so there is a sense that the reverse might also be true.

In an interview at the Wall Street Journal’s CFO Network Summit, Mester, who is a voting member of the Fed’s interest-rate setting committee this year, said she wants to shrink the balance sheet. She added the Fed could shrink the portfolio at a faster pace than in 2017 because the economy is stronger and the balance sheet is larger.

“I would like to reduce it — let me say this carefully, so that people don’t misunderstand — as fast as we can, conditional on not being disruptive to the functioning of financial markets,” Mester said.

On Tuesday, Kansas City Fed President Esther George, who is also a voting FOMC member this year, backed a fast pace of shrinking the balance sheet.

Read: Fed’s George urges faster drawdown of assets

The Fed shrank its balance sheet in 2017 by allowing a portion of its maturing securities to roll off the balance sheet each month. It did not sell any of its portfolio holdings.

In 2017, the Fed starting allowing $10 billion a month of rolling off and eventually ramped it up to $50 billion a month. The balance sheet shrank from a peak of $4.5 trillion in January 2015 to $3.8 trillion in August 2019.

One thing that is different this time is the Fed has a new standing repo facility to provide cash to the market if any strains emerge as the balance sheet gets smaller. In the last cycle, strains emerged in September 2019.

There are “rules of thumb” about what amount of balance sheet shrinking would equal a quarter-point hike in the Fed’s benchmark interest rates. But these studies always stress that it depends on current economic conditions, Mester said.

“I think we have to be humble” about the specific effects of reducing the balance sheet, she said.

“I think what we have to do is set out an appropriate path for shrinking the balance sheet” and then watch how the economy responds when the Fed raises its benchmark rate, she said. The two policy tools will move in the same direction.

With interest rates at zero, and the Fed still buying assets until mid-March, the central bank is a long way from having tight monetary policy, she noted.

Fed Chairman Jerome Powell told Congress on Tuesday that the balance sheet shrinking could happen later this year. Some Fed officials are pushing for an earlier start.

Read: Powell paints a picture of a soft landing

Michael Gapen, chief U.S. economist at Barclays, said he expects the balance sheet shrinkage to start in the second half of the year.

He estimated the Fed might want to take out $1 trillion from the balance sheet over the first year.

“I think they might get a fairly fast pace of runoff at the beginning,” he said in a Bloomberg Radio interview, perhaps around $60 billion-$80 billion a month after a slower start.

The Fed also has more short-term T-bills on its balance sheet than in 2017.

“You could get a lot of runoff fairly quickly, just by letting T-bills go,” Gapen said.

Stocks
DJIA,
+0.05%

SPX,
+0.23%
were higher on Wednesday and the yield on the 10-year Treasury note
TMUBMUSD10Y,
1.727%
slipped to 1.716%.

source

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