The Fed Should Keep Its Tools in Their Place

(Bloomberg Opinion) -- For the past year and a half, the U.S. Federal Reserve has been paring down the multi-trillion-dollar portfolio of securities it purchased to support the recovery from the 2008 financial crisis. Now, Chairman Jerome Powell has suggested that the Fed might end this “quantitative tightening.”

I think that would be a bad idea.

When the Fed announced its last monetary-policy decision, Powell explained that if the central bank decides to provide more stimulus to offset economic weakness, “we'll always be willing to adjust balance sheet policy.” As a result, most analysts now expect that at next month's policy-making meeting, any cut in interest rates will be accompanied by a decision to stop the gradual runoff of the Fed's holdings of Treasury and mortgage-backed securities (which is currently scheduled to end in late September). 

Those analysts might be right. But there are various reasons that pairing the decisions on the balance sheet and short-term interest rates would be wrong.

First, it would make the balance sheet seem more important than it is, particularly at a time when interest rates are well above zero. While President Trump has railed against the Fed's “quantitative tightening”, the actual impact on the bond market and financial conditions has been virtually imperceptible. Ending the runoff a couple months earlier will have a trivial effect on the central bank's holdings and on monetary policy. Other issues, such as the maturity distribution of the Fed's Treasury holdings, are far more significant.

Second, it would be a fundamental shift in the Fed's rationale for its balance-sheet decisions. To date, that rationale has focused on excess reserves: The larger the balance sheet, the more cash banks have to deposit on reserve at the central bank. The Fed chose to stop the runoff in September, because that would leave enough excess reserves in the system to prevent undesirable fluctuations in the Fed's target interest rate, which is also the rate at which banks lend reserves to one another. Deciding to stop earlier for a different reason will only engender confusion.

Third, it contradicts the Fed's earlier statements that short-term interest rates would be the primary tool of monetary policy, and that reductions in the balance sheet would run on autopilot in the background. By adjusting the runoff, the Fed would imply that it has two active tools for monetary policy and that they must never work at cross purposes, even trivially.   

Fourth, ending the balance sheet run-off earlier might create the impression that the Fed is succumbing to pressure from President Trump. In his public criticism of the Fed, President Trump has strongly opposed the central bank's quantitative tightening.

Let's not confuse people about the purpose of the Fed's balance sheet. If more stimulus is needed, the central bank should simply cut interest rates.

To contact the editor responsible for this story: Mark Whitehouse at mwhitehouse1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University's Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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