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An expected surge in fiscal spending is forcing top Fed policymakers to consider the speed of their monetary normalization process.
For the first time, that also appears to include seriously contemplating the massive balance sheet the central bank built in the course of conducting its quantitative easing programs during the first half of the decade, and the exact timeline for beginning to draw down its holdings.
Top officials have mostly avoided the topic in recent years, other than to point out repeatedly that a large balance sheet would be accommodative for financial conditions even if the bank tightens financial conditions through rate hikes. But it seems as if aggressive fiscal spending, the possibility of higher deficits and an economy running full steam could shift the thinking for some Fed officials — and they have begun to hint that they may soon be weighing beginning that process.
Policymakers have long made it clear that the first step in drawing down the balance sheet would be allowing its principal repayments to roll off the balance sheet rather than reinvest them. Fed Governor Lael Brainard noted in a Jan. 17 speech that such fiscal spending, along with faster growth and inflation pressures, could lead to more rapid policy adjustment, "with the conditions the FOMC has set for a cessation of reinvestments of principal payments on existing securities holdings being met sooner than they otherwise would have been."
For her part, Federal Reserve Chair Janet Yellen said in December 2016 that a change in the bank's reinvestment policy will not occur until its normalization process was "well underway." In a speech last week, she argued that downward pressure on long-term interest rates attributable to its balance sheet holdings were already abating. That amounts to a "passive" tightening of policy that could have an equivalent effect of lifting rates by about 50 basis points during the year, Yellen said.
The issue is one that involves a variety of considerations for the bank. Unspooling their balance sheet is as unprecedented policy territory for Fed officials as the series of quantitative easing programs that built it, and how exactly markets and the economy will react to such a step remains uncertain. The prospect of large-scale fiscal spending driving large federal budget deficits, in addition to the bank's own expected rate hikes, also could place major upward pressure on U.S. government debt yields of all maturities. Such a move in yields could subject the Fed to potentially large paper losses on its vast bond holdings. While Fed officials have argued that such losses would not impact the bank's functions, they might force the bank to suspend the income it pays out to the U.S. Treasury.
Perhaps just as importantly for the Fed, losses on its balance sheet could represent a major political risk for the bank as President Donald Trump and other Republicans who have been antagonistic toward the bank are the ascendant political class in Washington, D.C.
And it seems as if those factors will be enough to force Fed officials to craft and communicate a clear message to markets about their strategy for the balance sheet. Philadelphia Federal Reserve President Patrick Harker, a voting member on the FOMC this year, said after a Jan. 20 appearance that the Fed should consider halting reinvestments once the central bank's key interest rate reaches 100 basis points. With most Fed officials projecting that rates will reach those levels later this year, the process and timing of balance sheet reduction will likely be an area of increasing focus both within and outside the bank in the coming months.