The Federal Reserve has been tiptoeing around the giant elephantine balance sheet in the room for nearly a decade, but the clock is nearly up for them to make their long-term plans clear.
Long story short: the thing probably isn’t going anywhere anytime soon.
Chair Janet Yellen and other top officials have claimed for some time that they are eager to begin reducing their nearly $4 trillion in U.S. government and mortgage debt. And while this may be true at the margin, there is plenty of reason to believe that a balance sheet of a size that would have been unthinkable before the financial crisis will be with the Fed well after many current FedHeads have left the bank.
The truth is that though many of them may make noises about reducing the size of the balance sheet, a sizable and probably a majority of Fed officials believe that the monstrosity of U.S. government and mortgage debt is here to stay — indeed, most of them schooled in the modern central banking theories believe a rather large balance sheet is now an essential part of monetary policy (as usual, the cool kids in Tokyo have been at the leading edge of this trend since the 90s.) More than one Fed official has indicated that even a “normal” balance sheet as they currently envision it could total about $2 trillion worth of government and/or housing debt.
Holding a sizable balance sheet gives Janet Yellen & Co. a variety of policy options as they aim to dilute the economic punch bowl over the coming year or two, and an additional lever to old-fashioned, ho-hum interest rates certainly proved useful when their goal was to boost the economy after the Aughts Collapse.
And Fed policymakers have real trepidation about reducing the balance sheet, even from its current level. No one - really - has any actual idea about how big of an impact such a move would have on the economy. The Fed has been operating in uncharted waters since it first embarked on its asset buying campaign, and there is no uniform understanding if hundred of billions of dollars pouring off their balance sheet will actually be a “background event” for financial markets.
So they will move with caution — even more than they’re currently broadcasting — for fear of accidentally tightening financial conditions beyond where they hoped. Additionally, any hints of a slowdown or a (mathematically overdue) recession would almost certainly mean shelving any sort of major reduction in their asset holdings. Unless the entire developed world economy suddenly emerges from the deflationary pressures of the last decade, the financial considerations at play still ultimately point to the Fed remaining the owner of trillions upon trillions of U.S. financial assets.
However, there is one major risk related to the balance sheet that may be compelling enough for the Fed to show major progress toward moving away from a balance sheet dependent policy approach: politics. Quantitative easing has proved a fruitful vector for the resurgent populist movements on both sides of the American political aisle, as anyone who has ever watched Rep. Sean “Real World” Duffy stop getting nice and start getting real in a monetary policy hearing can tell you.
The real nightmare scenario for the bank, though, is that an economic crash leaves large losses sitting on its balance sheet and dries up the annual payments it makes to the U.S. Treasury each year. We’ll find out soon enough if the bank is more worried about inducing an economic crash, or holding the political bag if one occurs and offering its political opponents a real chance to seriously rein in its uniform control over monetary policy.
Robb Soukup is a freelance journalist who previously covered the banking sector and The Fed for S&P Global Market Intelligence.