“If the past repeats, the shrinking of the central bank’s balance sheet is not likely to be an entirely benign process and will require careful monitoring of the banking sector’s on-and off-balance sheet demandable liabilities”
— Raghuram Rajan, former Governor of the Reserve Bank of India and former Chief Economist at the IMF
The Federal Reserve wants to be able to shrink its balance sheet in the background with little fanfare, but this may be wishful thinking, according to a new research presented at the Fed’s summer conference in Jackson Hole on Saturday.
“If the past repeats, the shrinkage of the central bank balance sheet is not likely to be an entirely benign process,” according to the study. Shrinking the balance sheet is “an uphill task,” the paper by Raghuram Rajan, former Governor of the Reserve Bank of India and a former IMF Chief Economist and other researches concludes.
Since March 2020 at the start of the coronavirus pandemic, the Fed has doubled its balance sheet to $8.8 trillion by buying Treasurys and mortgage-backed securities to keep interest rates low to sustain the economy and the housing market.
The Fed stopped buying assets in March and set out a process to gradually shrink the portfolio. Officials view this as another form of monetary policy tightening that will help lower inflation along with higher interest rates.
The Fed started to shrink its balance sheet in June, and is ramping up next month to its maximum rate of $95 billion per month. This will be accomplished by letting $60 billion of Treasurys and $35 billion of mortgage backed securities to roll off the balance sheet without reinvestment.
This pace could reduce the balance sheet by $1 trillion per year.
Fed Chairman Jerome Powell said in July that the reduction in the balance sheet could continue for “two and a half years.”
According to the study, the problem is how commercial banks react to the Fed’s policy tool.
When the Fed is buying securities under quantitative easing, commercial banks hold the reserves on their balance sheets. They finance these reserves through borrowing from hedge funds and other shadow banks.
The researchers found that commercial banks don’t reduce this borrowing once the Fed has started to shrink its balance sheet.
This means that as the Fed’s balance sheet shrinks, there are fewer reserves available for repaying these loans which are often in the form of wholesale demand deposits and highly “runnable,” said Rajan, in an interview with MarketWatch on the sideling of the Jackson Hole meeting.
During the last episode of quantitative tightening, the Fed had to reserve course and flood the market with liquidity in September 2019 and again in March 2020.
“If the past repeats, the shrinking of the central bank’s balance sheet is not likely to be an entirely benign process and will require careful monitoring of the banking sector’s on-and off-balance sheet demandable liabilities,” the paper said.
Partly in response to the prior episodes of stress, the Fed has established a Standing Repo Facility to allow primary dealers, key financial institutes who buy debt from the government, to borrow more reserves from the Fed against high-quality collateral.
Rajan said this emergency funding “might not be broad enough to reach all the people who are short of liquidity.”
The paper notes that some banks, who have access to liquidity, might try to hoard it in times of stress.
“The Fed will then have no option but to intervene once again and lend widely as it did in September 2019 and March 2020,” the paper said.
This could complicate the Fed’s plans to raise interest rates to bring inflation under control.
Even more fundamentally, the researchers raise questions about the effectiveness of the opposite policy — quantitative easing — as a useful tool for monetary policy. Quantitative easing was used by the Fed to provide liquidity and support financial markets during the coronavirus pandemic in 2020.
Fed officials often justify QE by saying that it brings down long-term interest rates and allows more borrowing, but economists have said the evidence of this is scarce.
Former Fed Chairman Ben Bernanke once quipped that quantitative easing works in practice but not in theory.
The paper released at Jackson Hole argues that the actual evidence banks were not increasing borrowing by commercial customers during quantitative easing, but preferred to lend to hedge funds and other firms.
Instead of QE, central banks in Europe and Japan have moved to directly purchasing stocks and bonds of corporations and effectively financing them.
It might be appropriate for the Fed to appeal to fiscal authorities to support activity “since pushing on the string of quantitative easing when economic transmission is muted may only increase eventual financial fragility and the likelihood of financial stress.”