Fed Exit Looks Harder w/ New Buying

Photograph by Daniel Acker/Bloomberg

Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade.

Federal Reserve watchers such as Michael Feroli at JPMorgan Chase & Co. expect the central bank this week to bulk up its balance sheet again by adding $45 billion dollars of monthly Treasury purchases to its standing program of $40 billion monthly mortgage-backed securities purchases.

Inflation is still slightly below the Fed’s 2 percent goal at 1.7 percent for the year ending October, and the unemployment rate at 7.7 percent in November is far above its 5.2 percent to 6 percent definition of a sufficiently tight labor market.

Wall Street analysts haven’t decided whether to call it Quantitative Easing 4 or Quantitative Easing 3.5.

The real issue, however, is that the Fed’s balance sheet is likely to vault over $3 trillion, compared with a normal size of about $1 trillion. Today, total assets held by the Fed stand at $2.86 trillion.

The bigger the Fed’s holdings get, the less likely they will be able to sell these assets at a rapid pace when it comes time to raise interest rates because they would disrupt financial markets.

If the Fed can’t shrink its balance sheet, it might resort to other tools to mop up the cash it is creating. It could sell term deposits to banks and money market mutual funds. In effect, the Fed could end up looking a lot like a commercial bank. It would be paying interest on deposits to fund a large portfolio of housing bonds.

Marvin Goodfriend, who was a policy adviser at the Richmond Fed and is now an economist at Carnegie Mellon’s Tepper School of Business, points out that support of particular industries is risky for central bank independence. Today, the Fed is financing housing; tomorrow they could be pressured into financing some other segment deemed critical to America’s economic success.

The larger point is that nobody really knows what normal central banking looks like any more. Central bank mandates written by legislatures pay a lot of attention to low inflation, yet price stability isn’t the biggest worry just now. Central banks, including the Bank of England and the Bank of Japan, are doing what they can to boost growth, credit and employment, and may find it hard to step back from a broader mission even though they spent three decades explaining why low inflation should be their first and sometimes only goal.






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