Fed Chair Powell Faces Early Reckoning On Fed's $4-Trillion Question

Washington (Jan 29)  Federal Reserve Chairman Jerome Powell has a problem: how to explain that the Fed may soon begin to taper its ongoing asset-shedding operation without looking like he’s hunkering down for a coming recession, or caving to U.S. President Donald Trump.

Not long ago, Powell expected to face this delicate communication test some time later in 2019, rather than at his news conference on Wednesday following the close of the Fed’s first policy meeting of the year.

But three things - an unexpected scarcity of reserves deep in the plumbing of Wall Street, overt public pressure from investors and the White House, and the Fed’s own decision to rethink its interest-rate hikes - are forcing the U.S. central bank to acknowledge the real possibility of hanging on to more bonds than originally planned.

“You cannot stop the rate-hiking cycle without communicating on the balance sheet as well,” said Thomas Costerg, senior U.S. economist at Pictet Wealth Management, in Geneva, Switzerland.

A bigger balance sheet could result in an across-the-board easing of market borrowing costs and the foreign-exchange value of the dollar, easing strains on emerging markets. It could also affect the Fed’s appetite for bond buying in the face of a future U.S. downturn.

For more than a year, the Fed has methodically trimmed its multi-trillion-dollar balance sheet - from nearly $4.5 trillion to about $4.1 trillion and falling - without much notice.

Instead, it has kept the world’s eyes trained on a series of interest-rate hikes which, according to careful messaging from policymakers in recent weeks, may have come to an end.

But late last year, prominent investors took to blaming the Fed’s balance sheet runoff for market volatility. To underline what they saw as the harmful restraining effects of the Fed’s reversal of its bond-buying stimulus, the program known as quantitative easing undertaken during the financial crisis to jump-start the economy, they dubbed the runoff “quantitative tightening.”

In December, Trump amplified that theme, tweeting that the central bank ought not to “make yet another mistake” and “stop with the 50 B’s” - a reference to the $50 billion maximum in bonds by which the Fed has been shrinking its portfolio each month, according to a plan it outlined and began in 2017.

A day after the tweet, when Powell said the run-off remained on “automatic pilot,” the Standard & Poor’s 500 stock index delivered its worst 60-minute selloff in at least a year.

Two weeks later, when Powell stressed that the plan was actually flexible, the index delivered its best 60 minutes in at least a year.

Trump’s tweet exposed a dilemma for the Fed: though its 2017 plan divorced balance sheet policy from monetary policy, markets see a stronger connection. If the Fed is to stick to its guns on keeping the balance sheet from becoming a first-responder tool against economic ups and downs, Powell needs to keep that divorce on the books.

“I don’t think they’re going to stop,” said Chuck Self, chief investment officer at iSectors LLC, in Appleton, Wisconsin. “They want to get it down as low as they can without disrupting the economy.”

A CLEARER ROAD MAP

The central bank is indeed nearing the point at which it needs to adjust its balance sheet plan, not because of the state of the domestic economy, which appears strong, but because of the plumbing of short-term markets.

As the portfolio has decreased, banks have trimmed the reserves they keep at the Fed by even greater amounts, putting a strain on the Fed’s ability to control the short-term policy rate by which it steers monetary policy.

Reuters

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