Has the Fed entered a new policy regime?
By Neil Irwin
A lot of the chatter around yesterday's Federal Reserve policy statement latched onto the idea that we're in a new world for Fed policy, one in which it targets a size of the balance sheet as a major policy tool.
It's not a crazy conclusion to reach from yesterday's statement. The Fed is going to reinvest proceeds from maturing mortgage-related securities into Treasury bonds, essentially freezing its balance sheet at $2.054 trillion (excluding the portfolios that result from the Bear Stearns and AIG bailouts, which it intends to liquidate as quickly as market conditions allow).
Steve Liesman on CNBC yesterday even argued that we could now be in a world in which the Fed tweaks its target for the size of the Fed balance sheet at each meeting as a way to either heat up or cool down the economy--for example, if economic data is stronger than expected between now and the September meeting, the Fed could lower the balance sheet target to $1.75 trillion, or if the data is weak it could increase the balance sheet target to $2.25 trillion.
I don't think that's what the Fed had in mind. There's nothing special about the current $2.05 trillion level of the balance sheet; I doubt anyone on the FOMC would argue that that is somehow at a uniquely optimal level.
Rather, on Tuesday they faced this dilemma: The outlook for growth has softened in recent weeks and the risk of inflation diminished. Yet monetary was becoming less accommodative--because low interest rates are leading more people to refinance their mortgages, the securities in the Fed portfolio were being paid off even more quickly than they otherwise would have. Fed officials wanted to stop that process and keep monetary policy from tightening, and in the meantime signal to financial markets that they are on top of things and have policy tools remaining, should it come to that.
So they announced a freeze of the balance sheet at the more or less arbitrary level it stood at in early August. The big question in markets right now is what might change that, in other words, what is their reaction function?
My best guess is that the decision of whether to resume asset purchases and expand the balance sheet is binary, not linear. If growth truly appears to be stalling out, with second half GDP growth coming in somewhere south of 2 percent (forecasts are in the 3 percent plus range now), and/or year-over-year core inflation gets below about 0.8 percent, the Fed starts to talk about the big guns. If they pull the trigger on those guns, it would be an announcement of another asset purchase program in the hundreds of billions of dollars, primarily of Treasury bonds.
What they're not likely to do is do ongoing adjustments to their target for the balance sheet, raising or dropping their goal for balance sheet size based on the latest data (though that's what at least one FOMC member, James Bullard of the St. Louis Fed, would prefer). I base this in part on how they've done these things in the past--the previous installments of quantitative easing came in one-off announcements of very large numbers that are carried out over time. But more broadly, the exact impact of a larger balance sheet on economic growth and price levels is highly uncertain. It would be folly, many at the Fed would argue, to pretend that the tool is finely tuned enough to be constantly tweaking the size of the balance sheet in response to the latest data.
Quantitative easing is the sledgehammer of monetary policy, not a ball peen hammer. You don't know exactly where it will hit, or how much force it will carry.
August 11, 2010; 8:00 AM ET
Categories: Federal Reserve
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