By Trevor Hunnicutt and Ann Saphir
NEWYORK/SAN FRANCISCO (Reuters) – President Donald Trump last week called on the U.S. Federal Reserve to start building up its war chest of bonds again. He may get his wish – though not for the reason he wants.
The U.S. president on Friday said the Fed should cut rates and pursue an unconventional monetary policy called “quantitative easing” that was used to nurse the economy after the global financial crisis. The technique used from 2008 to 2014 involved buying trillions of government-sponsored bonds.
“It should actually now be quantitative easing,” said Trump, who has blasted the Fed for raising interest rates.
The Fed has been reducing its bond hoard as it works toward normalizing monetary policy. But later this year, it will stop shrinking the stockpile, leaving it holding more than $3.5 trillion in securities.
Before long the Fed will be considering when to start building up its bond holdings again, policymakers have said. Their goal at that point may not be to stimulate the economy but to keep enough money in the banking system so they can manage rates.
The balance sheet used to be much smaller – well below $1 trillion before the crisis. But changes since then to how banks manage their capital, how the Fed sets short-term interest rates, and the sheer growth in global demand for dollars have made a bigger balance sheet a necessity, Fed policymakers say.
Policymakers’ decisions on what the balance sheet will look like will have far-reaching impacts on the market and the economy. And views at the Fed are split on what is the right way to go.
Here are some facts about the balance sheet:
WHAT IS THEFED’S BALANCESHEET?
At its simplest, it’s an accounting of the Fed’s assets and liabilities. Assets include bonds the Fed bought once it had cut interest rates to zero and needed still more firepower to stabilise the economy after the 2008 global financial crisis.
The Fed’s liabilities include funds the Fed created to buy the bonds, many of which now sit in banks’ reserve accounts at the central bank. The liabilities also include paper money and deposits from the Treasury.
The Fed controls interest rates using its balance sheet. It does that in part by paying banks an interest rate on their reserves to influence other short-term borrowing rates.
(Graphic: The Federal Reserve’s balance sheet, https://tmsnrt.rs/2ULcay0)
WHY IS THEBALANCESHEETCONTROVERSIAL?
Once upon a time the Fed’s balance sheet was much smaller and minor tweaks in holdings could move the Fed’s target rate.
Bond-buying “quantitative easing” changed that. The programs were aimed at pushing down long-term borrowing costs so businesses would boost investment and hiring. Critics said the policies raised inflation and financial instability risks.
In 2017, the Fed began to let its balance sheet shrink in an effort to put policy back on normal footing. That too drew criticism, with Trump and investors accusing the Fed of tightening policy too far.
In March the Fed announced the runoff would likely end by September. Policymakers say ending the runoff will help them keep enough reserves in the system so they can manage rates. They rarely describe the policy change as an effort to stop tightening policy.
Yet many Fed policymakers say they will likely need to resort to bond buying to battle future economic downturns because, with interest rates between 2.25 percent and 2.5 percent, they have little room to cut before they get to zero.
HOW IS THEFEDPREPARINGFORRECESSION?
Four top Federal Reserve officials speaking since the March meeting suggested the central bank could hold more short-term bonds than it does now.
Doing so would shore up its ability to fight the next recession, they say, because it could easily trade in its short-term bonds for longer-term ones, putting downward pressure on borrowing costs without having to bulk up the balance sheet.
It’s an approach called a maturity extension programme, or “Operation Twist,” and the Fed did it 2011.
Federal Reserve Bank of Boston President Eric Rosengren and his counterpart in Chicago, Charles Evans, gave speeches suggesting that approach is being considered.
Philadelphia Fed President Patrick Harker went further, saying there is a “general consensus” to do so.
But two policymakers also noted a downside: Ditching long-term bonds could tighten financial conditions. To offset that problem the Fed might have to lower interest rates. That would make it more likely that rates would hit zero and then force the Fed to do more quantitative easing later.
And one policymaker, Minneapolis Fed President Neel Kashkari, suggested that buying short-term notes could look like the Fed was overtly supporting the U.S. government’s debt issuance. “I want to make sure everyone is clear about the political independence of the Fed,” he told Reuters in an interview. “My gut tells me, just buying across the curve is a more neutral stance, which makes me more comfortable.”
The Fed also wants to get back to a portfolio of mostly Treasuries, much like it had before buying mortgage securities after the crisis. But they have not decided if selling the securities makes sense.
“Clearly, much work is needed to decide on the portfolio … that will best help the Fed meet our … objectives,” Evans said recently. “I am open-minded on this question.”
Graphic: The Fed’s Treasury holdings by maturity, https://tmsnrt.rs/2Hv6Iwd)
A central bank that has spent the last 18 months cutting back the bonds it holds will have to consider when to start buying again.
Bank reserves will fall over time, for instance as financial institutions exchange reserves for currency. Since the Fed controls rates by paying interest on reserves it needs ample reserves in the system. It can create them and buy more bonds as it did after the financial crisis, Rosengren wrote. He said when such purchases will resume is a “significant issue going forward” for policymakers. They also have to decide how many bank reserves they need to control rates.
(Reporting by Trevor Hunnicutt and Ann Saphir; Editing by Andrea Ricci)