Reducing assets on the Federal Reserve's balance sheet is not likely to add significantly to rate increases, a group of Wall Street and academic economists suggest in a recent study.
"Our overall conclusion is that the size of the Fed's balance sheet is less potent in moving the bond market than as perceived by many and should not be viewed as a primary tool of monetary policy going forward," the economists said in a paper presented at the U.S. Monetary Policy Forum in New York on Feb. 23.
The authors said that lowering the short term rate — rather than another round of asset purchases — should be the primary instrument used by the Fed to deal with the next recession.
But William Dudley, the president of the New York Fed, disputed that contention in remarks prepared for delivery to the same conference. Dudley argued that large-scale asset purchases, or LSAPs, can still play in important role in monetary policy when interest rates are near zero.
"In such circumstances, LSAPs can be used to provide additional monetary accommodation by depressing bond term premia and the spread between agency mortgage-backed securities (MBS) and Treasury securities, as well as by strengthening the credibility of forward guidance on the path of short-term interest rates," Dudley said. "This can provide support to asset values more generally and make financial conditions more accommodative."
The Fed's asset buying program was a unique response to the 2008-2009 financial crisis. After cutting rates nearly to zero did not spur lending, the central bank embarked on an asset buying program that eventually swelled its balance sheet to $4.5 trillion.
Now that the Fed has begun normalizing its balance sheet, the paper's authors examined the question of how much the roll-off would add to rates.
There had been a consensus that the asset purchases lowered U.S. Treasury 10-year yields by about 100 basis points, the authors noted. But shrinking the balance sheet is not likely to produce a similar increase, the economists concluded.
"We find that the Fed's balance sheet is a less reliable and effective tool than as perceived by many, and that the central question going forward should be the path for short-term interest rates rather than the path of the balance sheet," the paper said.
The paper was prepared by David Greenlaw, senior desk economist at Morgan Stanley; James Hamilton, a professor at the University of California at San Diego; Ethan Harris, head of North America economics for Bank of America Merrill Lynch; and Kenneth West, a professor at the University of Wisconsin.