A senior official at the Federal Reserve Bank of New York on Monday said the US central bank should shrink its balance sheet “in a gradual and passive manner” as it moves towards tightening monetary policy.
Brian Sack, executive vice-president at the New York Fed, warned that a rapid sale of the assets accumulated during the financial crisis could be detrimental, leading to an unwanted spike in long-term interest rates. Thus, when monetary policy tightening begins, three major issues must be addressed: “First, this tightening cycle will have two policy dimensions, in that the [Federal Open Market Committee (FOMC)] will have to decide on the path of its asset holdings in addition to the path of the short-term interest rate. Second, we will be using tools to drain reserves that are new and that will have to be implemented on a scale that the Fed has never before tried. And third, we will be operating in a framework of interest on reserves that has not been fully tested in U.S. markets.”
“A decision to shrink the balance sheet more aggressively could be disruptive to market functioning,” Sack told the National Association for Business Economics (NABE) at a speech in Arlington, Virginia. Thus, a more passive approach in the short term, relying only on redemptions and not engaging in any sales, may be the better approach. Fed Chairman Ben Bernanke in his Feb. 10, 2010 testimony before Congress, described this approach. Sack continued, “In particular, [Bernanke] indicated that he does not currently anticipate that the Fed will sell any of its asset holdings until the economic recovery is more firmly established and policy tightening has gotten underway. Until that time, the portfolio would shrink only through asset redemptions. Chairman Bernanke noted that the Fed’s holdings of agency debt and MBS are being allowed to roll off the balance sheet, without reinvestment, as those securities mature or are prepaid, and that the FOMC may choose to redeem some of its holdings of Treasury securities in the future, as well.”
Sack noted that about $200 billion of debt on the Fed’s balance sheet would reach maturity by the end of next year. “Even under this cautious strategy of relying only on redemptions, the Fed could achieve a considerable decline in the size of its balance sheet over time,” he said. Hawkish Fed officials have been pushing for a more rapid unwinding of the balance sheet expansion that occurred during the crisis.
Dealing with the Fed’s balance sheet and excess liquidity in the market is also important ahead of raising the federal funds rate. Raising the target rate would be ineffective if the market is pricing overnight banks loans on the abundance of liquidity. “However, in order to ensure our ability to influence those other short-term interest rates, we have been developing two tools that can be used to reduce the large amount of excess reserves in the banking system—term deposits with banks and reverse repurchase agreements (reverse repos) with a broader universe of financial institutions,” Sack said.
On the issue of short-term rates, Sack offered some indirect insight. Because of the fragility of the economic recovery, the Fed is not expected to raise interest rates for months and is likely to reiterate that rates will remain at their current low target range of 0 percent-0.25 percent for an “extended period” when the committee meets next week. Sack seemed to confirm this expectation when he said, “the current configuration of yields and asset prices incorporates expectations that short-term interest rates will begin to rise around the end of this year. Thus, the markets seem prepared for the risks toward tighter policy.”
In a survey released on March 8, 2010, 66 percent of NABE economists agreed with present US monetary policy, although 63 per cent expected higher rates within six months.
For investors, the Fed’s policy likely means that equity markets have a clear path higher, at least until roughly the 3rd quarter of this year. However, when the Fed begins withdrawing liquidity in earnest, and especially when the initial rate increases come, markets will have a difficult time adjusting. Historically, during the initial months following Fed rate increases the equity market tends to decline, but six months or more later, it resumes growing again (assuming all is well with the economy of course). So, some combination of portfolio protection, or simply holding cash, will likely be a must come the second half of 2010 and especially towards the end of the year.
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Gregg D. Killoren
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Fed’s Monetary Policy Moves Important to Investors
A senior official at the Federal Reserve Bank of New York on Monday said the US central bank should shrink its balance sheet “in a gradual and passive manner” as it moves towards tightening monetary policy.
Brian Sack, executive vice-president at the New York Fed, warned that a rapid sale of the assets accumulated during the financial crisis could be detrimental, leading to an unwanted spike in long-term interest rates. Thus, when monetary policy tightening begins, three major issues must be addressed: “First, this tightening cycle will have two policy dimensions, in that the [Federal Open Market Committee (FOMC)] will have to decide on the path of its asset holdings in addition to the path of the short-term interest rate. Second, we will be using tools to drain reserves that are new and that will have to be implemented on a scale that the Fed has never before tried. And third, we will be operating in a framework of interest on reserves that has not been fully tested in U.S. markets.”
“A decision to shrink the balance sheet more aggressively could be disruptive to market functioning,” Sack told the National Association for Business Economics (NABE) at a speech in Arlington, Virginia. Thus, a more passive approach in the short term, relying only on redemptions and not engaging in any sales, may be the better approach. Fed Chairman Ben Bernanke in his Feb. 10, 2010 testimony before Congress, described this approach. Sack continued, “In particular, [Bernanke] indicated that he does not currently anticipate that the Fed will sell any of its asset holdings until the economic recovery is more firmly established and policy tightening has gotten underway. Until that time, the portfolio would shrink only through asset redemptions. Chairman Bernanke noted that the Fed’s holdings of agency debt and MBS are being allowed to roll off the balance sheet, without reinvestment, as those securities mature or are prepaid, and that the FOMC may choose to redeem some of its holdings of Treasury securities in the future, as well.”
Sack noted that about $200 billion of debt on the Fed’s balance sheet would reach maturity by the end of next year. “Even under this cautious strategy of relying only on redemptions, the Fed could achieve a considerable decline in the size of its balance sheet over time,” he said. Hawkish Fed officials have been pushing for a more rapid unwinding of the balance sheet expansion that occurred during the crisis.
Dealing with the Fed’s balance sheet and excess liquidity in the market is also important ahead of raising the federal funds rate. Raising the target rate would be ineffective if the market is pricing overnight banks loans on the abundance of liquidity. “However, in order to ensure our ability to influence those other short-term interest rates, we have been developing two tools that can be used to reduce the large amount of excess reserves in the banking system—term deposits with banks and reverse repurchase agreements (reverse repos) with a broader universe of financial institutions,” Sack said.
On the issue of short-term rates, Sack offered some indirect insight. Because of the fragility of the economic recovery, the Fed is not expected to raise interest rates for months and is likely to reiterate that rates will remain at their current low target range of 0 percent-0.25 percent for an “extended period” when the committee meets next week. Sack seemed to confirm this expectation when he said, “the current configuration of yields and asset prices incorporates expectations that short-term interest rates will begin to rise around the end of this year. Thus, the markets seem prepared for the risks toward tighter policy.”
In a survey released on March 8, 2010, 66 percent of NABE economists agreed with present US monetary policy, although 63 per cent expected higher rates within six months.
For investors, the Fed’s policy likely means that equity markets have a clear path higher, at least until roughly the 3rd quarter of this year. However, when the Fed begins withdrawing liquidity in earnest, and especially when the initial rate increases come, markets will have a difficult time adjusting. Historically, during the initial months following Fed rate increases the equity market tends to decline, but six months or more later, it resumes growing again (assuming all is well with the economy of course). So, some combination of portfolio protection, or simply holding cash, will likely be a must come the second half of 2010 and especially towards the end of the year.
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