Last week’s Federal Open Market Committee (FOMC) minutes leave little doubt the Fed is planning soon to start trying to unwind its massively bloated balance sheet. However, it is very doubtful how far the Fed will get in those efforts considering the size of the asset and credit market price bubbles that the Fed created when it expanded its balance sheet.
Now that the U.S. economy is showing signs of having reached full employment, the Fed is mindful that it needs to continue the process of monetary policy tightening if inflationary pressure is to remain well contained. In that context, the Fed is right to think that there are alternative ways to go about that tightening.
{mosads}The Fed can continue to raise its target short-term rate as it has been doing over the past year. Alternatively it can choose to shrink the size of its balance sheet by not rolling over at least part of those government bonds and mortgage securities it previously purchased when they fall due.
Such a course would likely cause long-term interest rates to rise as the Fed, in effect, became a seller of bonds in those markets. That in turn would have a similar restraining effect on aggregate demand as would the raising of the Fed’s target interest rate.
The real obstacles that the Fed will encounter when it tries to shrink its huge balance sheet are the global asset and credit market price bubbles that it created when it expanded its balance sheet from $800 billion in 2008 to around $4.5 trillion at present. It is not simply the fact that largely due to the Federal Reserve’s largesse, along with that of the world’s other major central banks, global equity and housing prices are at lofty levels and that these markets seem to be unfazed by any bad news.
Rather, it is that credit spreads across global debt markets now seem to be not offering investors with nearly sufficiently-high returns to compensate them for the likely risk of debt default. One important example of credit spreads being too tight is that in the U.S. high-yield debt market, where interest rate spreads today are at the very tight sort of levels that characterized this market on the eve of the 2008 economic crisis.
Other examples can be found in the emerging market debt market as well as in the European sovereign debt market and in the fact that the overwhelming majority of bank loans are now made in a covenant-lite fashion.
It is all too likely that as the process of Fed balance sheet unwinding gets underway, some external event will trigger a bursting of today’s asset and credit market bubbles. Such an event could take the form of a credit market reversal in a sizeable economy like Brazil or Italy. Alternately, it could be the result of a marked slowing in China, the world’s second-largest economy.
Once the world’s credit and asset market bubbles burst, the Fed will again start fretting about a shortage of aggregate demand. That will cause the Fed to put its asset unwinding program on hold and to start pondering ways to ease monetary conditions to provide support to the economy.
The moral of the story for the Fed should be that it should think twice before resorting again to highly-unorthodox monetary policies as it did over the past eight years. To be sure, it can be argued that those policies can provide short-term support to the economy.
However, one has to hope that the Fed will have learned that those policies came with the big price tag of distorting global asset and credit market prices in a big way, as well as setting up the stage for the next global economic crisis. It is also soon likely to learn that it is a lot easier to massively increase the size of its balance sheet than it is to bring its balance sheet down to a more normal level.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.
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