Lurking behind last week's FOMC decision to raise interest rates and predict higher growth next year is the specter of the Fed's monstrous balance sheet and the uncertainty about what happens as the central bank really begins to pull its support from bond markets in the coming years.
The outlook provided by the FOMC in its dot plot release last week puzzled reporters during the press conference and was certainly more muddled than investors would expect given the bank's ongoing moves to tighten monetary policy. Fed officials said that while they expected employment and wages to continue to improve through next year and 2019, as well as inflation to rise to their long-run target, they also estimate that growth will fall back to around the 2.0% level in 2019 after a spike next year.
Part of what Fed officials are recognizing with this outlook is that their reduction of the bank's balance sheet holdings over the next couple of years will likely cause a real drag on economic growth and presents a serious risk for both financial markets and the broader economy.
And the risks of both a growth drag and other potential unforeseen risks is likely to increase with time because of the plan upon which policymakers settled to reduce its asset levels. The majority of the FOMC announced agreed earlier this year that they would begin letting about $4 billion of mortgage-backed securities and $6 billion of of Treasuries roll of their balance sheet monthly; those numbers will rise each quarter until the central bank is letting $20 billion in MBS and $30 billion in Treasuries expire on its balance sheet each quarter. That means, then, that in a little over a year the asset declines will jump from $30 billion total on a quarterly basis to $150 billion and that in 2019 alone the Fed would see its balance sheet size fall by $600 billion.
Considering that Fed officials have long touted the positive effects of their quantitative easing programs -- especially the strong impact of their earlier rounds of asset purchases on financial conditions and GDP -- it should not be surprising that they foresee real downward pressure on growth when the full weight of the asset declines begin to hit, even as they predict that employment, wages and inflation will all move in favorable directions. One metaphor that increasingly comes to mind is avalanche control: the Fed is sitting on a mountain of liquidity that it needs to substantially reduce over time in the name of financial caution. At the same time it needs to do it in a way that does not trigger a larger economic convulsion and sweep away all of the economic gains of this decade -- which is a real possibility whenever central banks try out novel policies.
Of course, that's not the messaging that has accompanied the balance sheet drawdown. Most Fed officials across the policy spectrum (with the notable exception of Minneapolis Fed head Neel Kashkari) have gone out of their way to emphasize that they view the asset reductions as a background policy phenomenon, and one that will essentially run on "autopilot" and require little adjustment unless there is a major change in the economic and financial environment. That "nothing to see here" attitude was obvious during last week's meeting and press conference, when Chair Janet Yellen noted that the FOMC's policy statement did not discuss the balance sheet normalization and then avoided any real discussion of its potential impacts even though it is no longer theoretical and the Fed is presumably trying to estimate how it is affecting the economy.
There's another important factor at play with the balance sheet normalization process: how the Fed pulling its support from the MBS and Treasuries markets affects those markets, and by extension rates. The bank pretty reliably is able to hit the very target of its interest rate target, but it's reasonable to surmise that a smaller Fed balance sheet could tighten conditions across the financial world beyond where the Fed is setting its primary funds rate.
And as Kashkari noted in his essay on his dissenting vote, the yield curve has begun to flatten, which could be a warning sign of an impending slowdown or greater financial unrest moving forward. If the Fed's balance sheet normalization process hits the functioning of those markets harder than the bank expects, incoming Chair Jerome Powell and his colleagues could find themselves dealing with something much more severe than a step back in growth.