Not all “Fed speak” matters. Much of the time, Fed officials are stating the obvious or reiterating a previous statement or position taken by the Fed. The messages can become muddled and difficult to parse. Every official has his or her own view. In some cases, these views can be conflicting and confusing. There are times, however, when the tone and direction of Fed speak does matter.
The Fed's dot plot has been one of the most important indicators of monetary policy for the past several years. It gave markets a sense of how quickly or slowly the Fed planned to move interest rates and tighten policy. While an unreliable and often changed indicator, it was what the Fed gave us.
The Fed is shifting its attention (ever so slowly) to rolling off its balance sheet. The dots are likely to lose their luster as marginal tightening shifts from rate hikes to a tapering of reinvestment and more. Chair Yellen has stated that the balance sheet will be a powerful tool of tightening—potentially more so than rate hikes.
Until now, the Fed has been shy to discuss how it might shrink its balance sheet back toward a more normal size. The balance expanded as a result of quantitative easing (QE) and the associated asset purchases undertaken in the wake of the financial crisis. It appears the Fed may now be prepared to take small steps toward beginning the contraction.
QE involved purchasing two asset classes. Mortgage-backed securities (MBS) and US Treasuries. To shrink the balance sheet, the plan (as far as can be deduced) is to reduce mortgage-backed securities first.
Because the Fed will be targeting the reduction of the MBS portfolio, there is actually a good chance it will be buying US Treasuries while it allows the MBS to roll off. This is to avoid shrinking the balance sheet too quickly and tightening policy too quickly. This would provide (to use the not entirely reassuring phrasing used by New York Fed President Dudley) for a "softer landing."
For a brief moment, it looked as though Trumponomic sentiment was going to push the Fed’s plans aside. But this did not last long. As soon as sentiment data began to pick up and Fed officials were able to include fiscal spending and tax breaks in their economic projections, they started talking about reducing their expanded balance sheet.
Previous Fed Chair Ben Bernanke, in a footnote of a piece written for the Brooking's Institute, laid out what Fed officials generally thought on the topic of balance sheet reduction. Bernanke pointed out that some simply wanted to discuss a timetable while others wanted to define when the discussion or process would begin.
Chair Yellen has made it clear that the balance sheet would remain untouched until normalization was “well under way.” While there has never been a formal definition of what that means, Philadelphia Fed President Harker stated that a 1% Fed funds target would suffice to begin the discussion. Currently, the Fed funds rate is targeted in the range of 0.75 to 1%.
This is a good discussion to have. The Fed may well need its balance sheet again—and sooner rather than later. With little room to move the Fed funds rate in the near future, QE or a similar alternative will likely be necessary to combat any downturn. Creating room on the balance sheet is a proactive step, not simply in normalizing policy, but in preparing to combat the next recession (though this may not be the stated reasoning from Fed officials).
Quantitative Easing was a powerful tool for loosening policy, and it will be a powerful tool for tightening policy as well. One fear is that the Fed will underestimate the power of its reversal of policy and tighten too quickly.
Commentary around the Fed’s confidence in the US economy should be carefully considered as well. Officials have stated that their outlooks are a significant piece of determining the timing of balance sheet reduction. In some cases, these outlooks are directly tied to fiscal stimulus. Simply put, any upside risk to Fed forecasts will be fought, not with more rate hikes, but with the balance sheet.
This also signals that balance sheet reduction will be the most susceptible to fiscal stimulus disruptions. In the case of an economic disappointment, the Fed would begin to scale back plans to raise rates only after pushing balance sheet run-off down the road… and that will be a much higher bar.
Fed officials may do well to avoid saying much more about the balance sheet for the moment. But—if reduced—it will be the primary source of tighter monetary policy down the road. The process will have false starts and hiccups. Understanding how Fed officials see it unfolding will be one of the more important economic developments of the next year or so. Not to mention, if the time frame holds, balance sheet reductions will commence at the same time that Janet Yellen steps aside for a new Fed Chair early next year.
One question outstanding is how the Fed will communicate its intention on the balance sheet. Will there be a roll-off chart for economists to obsess over?
At any rate, the balance sheet normalization will be a long process. With little knowledge of how to do it or what the consequences might be, it will not be straightforward.