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Having ballooned in the years during and after the global financial crisis, the U.S. Federal Reserve put its $4.5 trillion balance sheet on a diet in 2017, but analysts are skeptical of whether it will end up much slimmer.
In the 11 months since starting the downsizing effort, the Fed has managed to lower the figure to $4.2 trillion. Fed Chairman Jerome Powell has said the balance sheet will end up no bigger than it needs to be, suggesting a range between $2.5 trillion and $3 trillion. But some believe the balance sheet may stay well above that range, a development that could have a significant impact on interest rates, emerging markets and an array of asset classes.
Jay Bryson, global economist at Wells Fargo Securities, estimated the central bank may end its unwinding process in late 2019 or early 2020, finishing with a balance sheet of roughly $3.7 trillion. At that point, he wrote in a research note, the Fed's balance sheet would likely need to grow again to keep pace with the amount of currency outstanding.
The Federal Open Market Committee discussed the future of the balance sheet at their August meeting, and Powell suggested that the FOMC "would likely resume a discussion" of the issue in the fall, according to the minutes of the meeting.
There is little chance that the Fed will go back to the precrisis level of about $850 billion, analysts agree, noting that the amount of cash added to circulation since that time limits how much it can cut from its assets.
Still, the Fed has several options at its disposal as it weighs the ultimate size of the balance sheet, with several political and practical considerations at play.
Fed may avoid return to old interest rate framework
A major part of the decision boils down to whether the Fed wants to go back to its old way of managing its key interest rate.
Under the precrisis system, known as the "corridor" system, the Fed would set a specific target for its benchmark federal funds rate. Fed officials would have to calculate banks' daily demand to borrow in the federal funds market. The New York Fed would conduct open market operations by buying and selling government securities to steer the federal funds rate toward the target.
The central bank's prior approach worked when there were few reserves in the banking system. Shortages of reserves meant that banks had to borrow from each other often so they could meet regulatory reserve requirements. But the Fed's quantitative easing purchases flooded the system with those funds, reducing banks' need to borrow.
Lorie Logan, senior vice president at the New York Fed, said in a speech in May that a return to the exact precrisis framework could be difficult, partly because new regulations have pushed up banks' demand for reserves, making the daily calculations much harder for officials.
"Some observers see a return to the Fed's precrisis, reserve-scarce corridor system as the natural conclusion to the normalization process," she said. "But it is important to note that fundamental changes in the money market landscape over the past decade would likely make monetary policy implementation in a future corridor system look substantially different than before the crisis."
The Fed would need to slash reserves significantly in order to resume its old approach, analysts say. But it could decide to keep a large supply of reserves as it has under its current model, which is "working really well," James Orlando, a senior economist at TD Economics, said.
"There's really no pressure for the Fed to go back to their previous way of doing things," Orlando said.
The current process, known as the "floor" system, relies on the Fed setting a 25-point target range for the federal funds rate. The central bank uses its rate on excess reserves, known as the IOER rate, to help ensure the Fed's key rate remains within the 25-point range. While the Fed made a technical change in June to prevent the benchmark rate from surpassing its target range and could make similar modifications again, analysts say the current framework has performed well overall.
"My view is that ... the Fed is going to stick with an abundant reserve regime, just because it's much easier for them to implement from a monetary policy perspective," said Mark Cabana, a former New York Fed official who is now a rate strategist at BofA Merrill Lynch Global Research.
Bigger balance sheet could mean more scrutiny from Congress
But an excessively large balance sheet could carry political risks for the Fed, as former Philadelphia Fed President Charles Plosser recently warned.
In a speech earlier this year, Plosser said the U.S. Congress could see an opportunity to "turn the Fed's balance sheet into a huge hedge fund" that would invest in projects that lawmakers back. For example, he said, an infrastructure bill from Congress could require the Fed to buy up development bonds and fund those purchases by increasing banks' excess reserves, similar to the structure the Fed undertook in its QE program.
Congress has already turned to the Fed to help finance some priorities, Plosser noted. Congress used surplus money at the Fed to help fund part of transportation package in 2015, and made a similar maneuver in a budget deal earlier this year.
"Fed independence is fragile and is gradually being eroded," Plosser said. "Offering the fiscal authorities a balance sheet to conduct fiscal policy or credit allocation off budget is akin to opening Pandora's box."
Both major U.S. political parties already have slammed the interest the Fed pays to financial institutions for the excess reserves they store with the monetary body, equating them to a subsidy for banks. That criticism that could sharpen if the Fed decides to continue holding a large balance sheet.
Fed officials have defended the payments, arguing that they are critical to the Fed's current method of conducting monetary policy.
Congress authorized the Fed to make such interest payments starting in late 2008, but the cost of the move is rising as the Fed continues to lift short-term interest rates. The Fed remitted $11.3 billion less to the Treasury Department in 2017 than it had a year earlier, largely because the increased interest payments to banks ate into its profits.
The scrutiny from Congress could intensify if the impact from rising rates continue to cut into Treasury remittances, Deborah Lucas, a former chief economist at the Congressional Budget Office, said. Lucas, who now leads the Massachusetts Institute of Technology's Golub Center for Finance and Policy, said Congress "could take actions to limit" the Fed's independence if lawmakers feel the central bank is straying from its traditional bounds.
"The larger their operations, the more their operations stray from their very basic mission, the more likely it is that they'll do something that catches the attention of someone who doesn't like what they're doing," she said.