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Shrinking the Fed’s $8.9 trillion balance sheet could get tricky

Mary Daly’s office overlooks the San Francisco Bay. The landscape helped the president of the Federal Reserve Bank of San Francisco find her analogy of choice to explain the Fed’s balance sheet: a tanker.

“It’s big. It turns, but not gracefully. It’s not very nimble,” Daly said in an interview last week. “You have to know where you’re going and what you’re doing. But this eventually brings you to the destination point.

At present, that destination is to control inflation. One of the ways Fed officials have tried to do this is to raise its key interest rate, the federal funds rate, which Daly says moves less like a tanker and more like an off- edge.

During the financial crisis of 2008, policymakers reduced this rate to zero to increase the availability of credit. With so little leeway to fix credit markets and help the economy recover, they turned for the first time to a less conventional tool: the balance sheet. And Daly said it worked well.

“I think it’s a critical part of our toolbox because ultimately we have to provide the support the economy needs,” Daly said.

The balance sheet, which shows the central bank’s portfolio – including Treasury debt and mortgage-backed securities – totals nearly $9 trillion. Last month, the Fed began allowing these holdings off its balance sheet refraining from reinvesting the proceeds maturing securities.

But using both tools — the fed funds rate and the balance sheet — to adjust monetary policy can be tricky.

“How can we get somewhere nimbly when we have a speedboat and a tanker, and we have to move them more or less at the same time?” Dally said.

The Fed does not want to surprise the markets. Late last year, policymakers announced their intention to start trimming the balance sheet before starting to raise rates. Daly said first interest rate hike in March could have come earlier if the balance sheet hadn’t been a factor.

There’s a lot we don’t know about how the balance sheet works, said Harvey Rosenblum, a former research director at the Federal Reserve Bank of Dallas who now teaches at Southern Methodist University. Rosenblum has his own balance sheet analogy:

“A new drug has been invented to treat a particular problem. But no one knows what the right dosage of this drug is. No one knows what its long-term impact will be. Nobody knows if if you use it too long it’s going to be toxic,” Rosenblum said.

Yet Fed officials triggered four waves of asset purchases that expanded its balance sheet — a process known as quantitative easing. Three of these waves took place between 2008 and 2014. The fourth came in response to the pandemic.

Rosenblum said quantitative easing was originally meant to be a temporary fix. But like many drugs, it’s less effective the longer you use it, he said.

“You need a bigger, bigger, bigger, bigger dose to have the same impact,” Rosenblum said.

As the Fed has clawed back assets to carry out this policy, some are wondering: at what cost? Former Fed economist Andrew Levin, who is now a professor at Dartmouth College, said the Fed now owns more than 40% of all residential mortgage-backed securities.

“He has a very large footprint in this market. All market players know this. Pension funds, life insurance companies,” Levin said.

Levin fears the buying frenzy has created the potential for distortions in this and other markets. He is among those currently analyzing the costs and benefits of the Fed’s balance sheet program. There’s a lot to learn about the effects of the balance sheet on the economy, said Megan Greene, chief global economist at Kroll and senior fellow at Brown University.

“It’s not clear that it’s the Fed that’s actually buying any of this stuff that moves the markets,” Greene said. “It could just be their announcement of an intention to [buy assets] that moves the markets.

The central bank has only tried to shrink the balance sheet once before, between 2017 and 2019. It had to stop after short-term borrowing costs soared. That’s the kind of volatility Fed policymakers want to avoid this time around.

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