The original plan for balance sheet shrinkage, articulated by Bernanke in the States, and Mervyn King in the UK, was organised around the idea of spending as small an amount of time as possible using QE as the marginal tool of adjustment for monetary policy. This in turn flowing from the idea that the effects of QE are ill understood, so best not to rely on it if you don’t have to. [I think this argument has flaws, which I’ll write about in another post].
The corollary of this idea was that you should wait to shrink QE stocks until you were sure that there was little chance of having to reverse them and start QE again [which means using QE as the marginal tool of adjustment]. And that in turn means waiting until the economy had recovered to the point that enough interest hikes were warranted that there was a lot of room above the zero bound to cope with responding to the next recessionary shock.
If you take FRB St Louis President James Bullard at face value, we may get shrinkage before another hike in rates. This seems like a change of plan, since interest rates are only at 1.25%, leaving very little room to cope with future shocks, given some plausible guess at what the distribution of those shocks looks like. To give a rather extreme comparison: central banks were hoping for something like -8% interest rates in the darkest days of the Great Financial Crisis. This is after starting at 5-6%. So if they could only have smashed through the zero bound, they would have liked a 13-14% rate cut. 1.25% therefore gives the Fed room to respond to a shock about 1/10th the size of the GFC without reversing course on QE.
There are two ways of rescuing the idea that the plan is being stuck to.
One is that the average maturity of QE holdings in the US is short, so the shrinkage can be achieved by simply letting assets mature rather than outright sales. So if the balance sheet has to grow again, new purchases won’t be following sales. If you believe that only actual sales or purchases matter [it’s the flows not the stocks that matter] then this is not a reversal. It’s purchases following natural wastage, not purchases following sales. However, this is pretty much the opposite of what the event study analysis [including work by Fed staff] says: ie it’s stocks, not flows that matter. Natural wastage shrinks the balance sheet; purchases grow it. So natural wastage followed by purchases is a reversal of the stocks.
A second way to rescue the ‘no change to plan’ view is that there is reason to be very optimistic about the future distribution of shocks. You’d have to be a brave person to hold that view. And also this view is not consistent with the chatter about raising the inflation target, which suggests that the Fed is conscious of the worry that the distribution of shocks is much less favourable than when the old 2 per cent target was designed [more room for responding therefore needed, which raising the target provides].
If this is a change of plan, why has it happened? Is it because the FOMC are worried about extra hostility towards QE from Congress and the White House, which has tilted rightward since Bernanke’s time?