Much Ado About Hypothetical Fed Moves

Last Wednesday, Fed head Jerome Powell and his merry board of governors treated Fed-watchers to a monetary policy twofer: In addition to holding rates steady, the Fed issued guidance on its balance sheet unwinding plans that some believe reflects a newfound willingness to pause, reverse or stop reducing its balance sheet sooner than previously planned—maybe even immediately. Many breathed a sigh of relief, presuming recent volatility shows the Fed’s balance sheet unwinding removes a key support from the economy and stocks. In our view, however, it was never a threat to either—and the Fed’s new guidance (to the extent it even amounts to that) changes little.

First, a bit of history. The Fed’s QE program had two purposes: Bolstering bank balance sheets gutted during the Financial Crisis and boosting lending by lowering long-term interest rates. Purchasing bonds from banks en masse—QE’s basic premise—did improve their balance sheets, and thanks to higher demand for long-term bonds, long yields fell. Superficially, this looks like a success. But the lower long-term yields negated QE’s other goal. When long rates fell while the Fed kept short rates fixed near zero, the yield curve flattened, discouraging lending. To see why, consider banks’ business models. Long rates determine their loan revenues (think of mortgage and corporate lending), while short rates represent a cost—primarily, interest paid on deposits. Hence, long rates minus short rates constitute a proxy for banks’ lending profits—and a smaller gap means fewer profits. The consequence: Broad US money supply growth—which lending fuels—has grown the slowest of any expansion on record. That makes the “easing” part of QE a misnomer, in our view—it actually tightened financial conditions.

So we welcomed the Fed’s 2013 decision to “taper” QE—reduce asset purchases—as well as its 2017 decision to start letting bonds on its balance sheet mature rather than reinvesting the proceeds. This process is called “balance sheet unwinding” or “quantitative tightening” (QT)—but again, we don’t buy the “tightening” part. Less downward pressure on long rates promotes an incrementally steeper yield curve than we might otherwise have—a positive. Though a very small one, as the pace of sales—$50 billion per month currently—pales next to the $15.6 trillion in outstanding Treasurys.^[i] This helps explain why 10-year yields have risen just 0.36 percentage point since QT began in October 2017.^[ii]

QT’s snail’s pace also casts doubt on the idea it exacerbated December’s volatility. The Fed’s initial unwinding path had QE ending in early 2024, if it decided to shrink its balance sheet to pre-QE levels, which it never outright said. Unwinding was also in the cards since June 2017, when the Fed first announced it. Markets are efficient—they price in such plans (and expectations about their effects) long before they happen. Fixation on an old fear can impact sentiment, but that doesn’t mean it has a fundamental impact.

While hints that the Fed might tweak its balance sheet reduction path—perhaps suspending unwinding for good—garnered much attention, any moves are theoretical at present. The Fed’s “Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization” last Wednesday doesn’t say it will necessarily slow QT or target a higher long-term balance sheet level than some previously undisclosed point—it suggests policymakers will think about it. Which … isn’t new: The Fed’s statement from June 2017 announcing its QT roadmap contains some of the same verbiage: “Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.” Allow us to translate: “If we wanted to enlarge the balance sheet at some point to support the economy, we could do that.”

That is pretty noncommittal! And judging by Powell’s answers in the post-Fed meeting press conference, the ambiguity is intentional. Consider this smorgasbord of caveats and TBDs: “I’m not going to give our estimate or ratify anybody else’s estimate of what the equilibrium balance sheet is here today. There are estimates out there but I’m not at a point today where I’m going to be giving out numbers on that. But there are estimates and I think they’re consistent with what I said, broadly speaking. … Again, we haven’t made any decisions. No decisions have been made. There are different pieces of the thing and [slowing QT] is in the discussion as one of many pieces that is in the discussion and that was reflected in the last minutes, actually. … There’s no cookbook here, there’s no playbook. No one really knows.  … We don’t think we have a precise understanding of this at all. I want to be clear about that. These estimates are fairly uncertain.”

Good luck sussing out a definite change in the Fed’s unwinding plans from that. About the only change we can see here is that Powell is finally learning the art of nebulous Fedspeak after headlines pilloried him for saying QT was on “autopilot” in December and derided his “plainspeak” in the run up to this month’s meeting.

Even if present speculation proves true and the Fed decides to slow or end QT altogether, we think the change is likely too small to matter. In the vast market for US Treasury bonds, whether or not the Fed lets $50 billion a month mature (and for how long) is small potatoes—particularly given markets’ ample opportunity to digest any changes long before they would take effect. So instead of overthinking the impact of words or small potential monetary policy changes that could very well play out years from now, we encourage investors to watch what the Fed does, when it does it. Speculation beforehand isn’t worthwhile.