The immediate decision facing the Federal Reserve when it meets in Washington isn’t that momentous. The nation’s central bank will likely continue scaling back its support for the economy by reducing the long-term bonds it is buying by another $10 billion, following a path laid out more than six months ago.
But the bigger question is what’s at the end of that road. In the days leading up to the end of the meeting and Fed Chair Yellen’s press conference on Wednesday, we’ll take a look at the debates that are shaping the central bank’s final destination.
When will the Fed end reinvestments?
It's often overlooked that the Fed's bond-buying program has two components: The central bank has not only added more than $1 trillion to its balance sheet, it's also spending billions more to ensure that level never shrinks.
To explain: Even though the Fed is buying long-term Treasuries and mortgage-backed securities, "long term" doesn't mean "static." Some portion of those bonds either mature or get paid back each month, reducing the Fed's total holdings and counteracting its goal of loosening financial conditions. That means just keeping its balance sheet stable requires the Fed to buy bonds each month to make up for the ones that have rolled off.
The so-called "reinvestments" were almost negligible in comparison to the trillion-dollar-plus behemoth that is QE3, the Fed's latest effort to jumpstart the recovery through bond purchases. But they could soon take center stage as the Fed winds down QE by the end of the year. Under the plan adopted in 2011 to guide the Fed's exit from its extraordinarily large balance sheet and zero percent interest rates, the next step would be to end reinvestments, followed by the first rate hike since the recession.
But now officials aren't so sure of that strategy.
Several Fed presidents have floated alternatives designed at least in part to preserve the central bank's flexibility in timing the first rate hike. That is turning the debate over reinvestments into a proxy for the upcoming battle over when to lift off on rates.
The most influential argument comes from New York Fed President William Dudley, who laid out a case for continuing reinvestments until after the Fed raises interest rates. He worries that the markets could overreact when the Fed decides to stop reinvestments by equating it with an imminent move in the fed funds rate. By taking the interim step off the table, the central bank could move more nimbly -- in both an easier and tighter direction. Here's an excerpt from Dudley's speech on the issue last month. (San Francisco Fed President John Williams has also supported this plan.)
There are two considerations that suggest to me that ending the reinvestments prior to lift-off may not be the best strategy. First, such a decision might complicate our communications regarding the process of normalization. Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the Committee’s intention.
Second, when conditions permit, it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa. Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.
Note that Dudley doesn't mention how long after raising rates the Fed would have to end reinvestments. That seems to suggest a comfort with the heftiness of the balance sheet from both a technical and philosophical standpoint. If a $4 trillion balance sheet doesn't compromise the Fed's ability to conduct monetary policy--and the idea of the central bank being so heavily invested in the mortgage market doesn't bother you--what's the rush to shrink the ledger?
Former Fed Chairman Ben S. Bernanke had already hinted that the central bank may not need to actively sell its portfolio but could simply let it run off naturally. Now the question is: Would it even have to do that any time soon?
That idea doesn't sit well with Fed policymakers who have long been uncomfortable with the unprecedented size of the balance sheet. Kansas City Fed President Esther George, for one, believes the central bank should stick to its original plan -- which, by the way, passed with all but one official dissenting. It would also represent a tiny step toward tighter policy and remove support from the housing market while it may still need help.
A middle path comes from Boston Fed President Eric Rosengren. In a speech earlier this month, he suggested a gradual reduction in the amount of reinvestments. In other words, another taper. But that raises a whole host of questions around the timeline and conditions of Taper 2 that may simply not be worth the effort.
In one scenario, a reduction in the balance sheet, when that becomes appropriate, could be implemented as a basically seamless continuation of the tapering program used for reductions in the purchase program. For example, the Committee could decide to reinvest all but a given percentage of securities on the balance sheet as they reach maturity, and increase that percentage at each subsequent meeting, assuming conditions allow.
Such a tapering of the reinvestment program could allow for a gradual and transparent reduction in the Fed’s balance sheet. As the economy moved closer to the Federal Reserve’s 2 percent inflation target and full employment, there could be a gradual reduction in the reinvestment policy – which would allow for a predictable reduction in the size of the balance sheet.
The disparity of views on reinvestments shows just how much work Fed Chair Janet Yellen has to do to achieve consensus on the committee that sets the country's monetary policy -- and the real battle over an interest rate hike has yet to begin.