The Fed’s balance sheet is normal and political


The author is an FT Contributing Editor

These are not normal times. US inflation measures are higher than they have been in four decades. When the Federal Reserve meets next week, however, it is likely to begin what it calls “normalization”: shedding as many assets as possible from its $9 trillion balance sheet.

Once complete, normalization will allow the Fed to resume using its old-fashioned tools: it will raise or lower interest rates, to discourage or encourage lending.

It’s hard to overestimate the appeal of normalization within the Fed. Central bankers are not like athletes. They don’t enjoy stressful moments of high performance. They are happiest when no one else thinks of them, when no one can accuse them of doing something wrong or, much worse, of doing something political.

Normalization, for the Fed, means a retreat from politics toward the safe and blameless behaviors described in the macro textbooks. It’s an understandable urge, but it demands that policymakers get it wrong in two ways.

First, after the last two crises, balance sheets are now a normal political tool. The Fed will have a very big balance sheet for a very long time; as long as it exists, it functions as a tool. And second, every choice the Fed makes — whether it holds, sells, or trades assets — helps some people more than others. All monetary policy tools have distributional consequences. Money is inherently political.

In a pre-pandemic review, Fed policymakers decided that if there was another downturn, they would do what they had done after the financial crisis. They would lower interest rates and then buy all the assets they had to keep financial markets functioning. Once rates hit zero, they would start buying Treasuries, methodically, until conditions improve.

Once the pandemic hit, that’s almost exactly what they did. When credit markets seized up, the Fed showed creativity and urgency, working with the US Treasury to secure markets for money market mutual funds, commercial paper, corporate bonds and municipal bonds. He supported emergency loan programs for large and small businesses. Then, according to its plan, once interest rates hit zero, the Fed methodically began buying $3.1 billion in Treasuries and $1.4 billion in mortgage-backed securities. .

At a meeting well before the pandemic, policymakers agreed that after an emergency had passed, they would prefer to buy Treasuries, to avoid the onset of what they called credit allocation – the political act of deciding who gets credit and who does not. Now, as it begins to normalize, the Fed has confirmed that it wants to return to a balance sheet with Treasuries and nothing else. The purchase of mortgages, for example, was a means of allocating credit to the housing market, a political act. About a third of Americans rent, and they’re much more likely to be young and single, black and Hispanic.

However, the purchase of Treasury bills was also a political choice. There are arguments, even among central bankers, about how buying billions of dollars of government debt helps reduce unemployment. This could work through the “signal channel” as a sign to investors that the Fed intends to keep rates low for some time. This could work by driving down 10-year Treasury yields and encouraging riskier long-term investments.

Or it could work through the “supply channel” – buying a large number of Treasuries reduces the yield on Treasuries, encouraging investors to buy something else. Indeed, that is what he seems to have done. If you owned any type of asset before the pandemic — a stock, a bond, a house, a start-up looking for another round of venture capital funding — returns over the past two years have been amazing.

The good news for the Fed is that buying a lot of Treasuries is not allocating credit. The bad news is that this is a return allowance. If you didn’t own an asset, you didn’t get the return. Only half of American families hold stocks and bonds in a retirement account. Buying both mortgages and treasury bonds was a political act.

The Fed doesn’t just have to have Treasuries on its balance sheet; it is to choose. A 2020 paper by Fed researchers, for example, pointed out that it was possible under current law for the Fed to provide low-cost loans to banks on the condition that they lend to businesses. and to consumers. The Fed does this in times of market stress, the researchers pointed out, but not as a normal tool to encourage employment – ​​the “political economy” risks were too great. You don’t see the Fed encouraging personal and business lending too often because then it could be accused of encouraging personal and business lending.

As it normalizes, the Fed will likely enter another long period of self-examination, with a view to using its balance sheet in the next crisis and subsequent downturn. When this is the case, it may help to remember that the policy tools of the Fed are not laws of physics that must be obeyed. These are choices. And they are always political.


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