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EXCERPT FROM ISSUE 60: THE RUNDOWN ON RUNOFF | September 11, 2017

TOPof INTERVIEW WITHMIND BRIAN SACK
Brian Sack is Director of Global Economics at the D. E. Shaw group. Prior to joining the D. E. Shawgroup in 2013, he was an Executive Vice President at the Federal Reserve Bank of New York (FRBNY),
where he served as head of the FRBNY's Markets Group and managed the Federal Reserve's System
Open Market Account portfolio from 2009 to 2012. Below, he reflects on the experience with the Fed’sasset purchase programs and argues that the Fed should maintain a relatively large balance sheet
and be willing to deploy it as a policy tool during future downturns.
The views stated herein are those of the interviewee and do not necessarily reflect those of Goldman Sachs.
Allison Nathan: You were involved in both establishing
quantitative easing (QE) as a policy concept andimplementing it after the financial crisis. Looking back, howimportant was QE to the economic recovery?
Brian Sack: QE proved to be a critical policy tool. Without it, theeconomic recovery would have been slower, and there wouldhave been a greater risk of the economy getting stuck in a
deflationary trap. Given that the Fed's traditional policy
instrument, the federal funds rate, was constrained by the zerobound, it was very important for the Fed to convey that it still
had an instrument that it would actively use to pursue its
economic objectives. I think that message had very meaningful
effects on expectations for the economy and on financial
conditions in a way that ultimately supported the recovery.
Allison Nathan: Can we really call QE a success, given that
inflation remains below the Fed’s target?
Brian Sack: It’s true that inflation has been disappointing. Thatbeing said, the low level of inflation today, if anything, highlights
how important it was for the Fed to have been responsive withthis policy instrument. If the Fed had sat on its hands andallowed a much more sluggish recovery, I think the problem oflow inflation would have been more severe.
Allison Nathan: Through what channel did QE impact theeconomy most?
Brian Sack: In my view, QE worked primarily through theportfolio balance channel. By reducing the amount of duration
risk that would have otherwise been in the market, QE pushed
down the term premium for longer-term securities, thereby
reducing those interest rates. As investors sought to substituteinto other securities, there were positive knock-on effects tobroader financial conditions. There may have also been someeffect through the signals that QE provided about the path of
the federal funds rate, but my intuition is that it was lessimportant than the portfolio balance channel, especially

Allison Nathan | allison.nathan@gs.com

considering that the Fed was separately providing explicit
guidance on its policy rate over much of this period.
Allison Nathan: In retrospect, is there anything that the Fed
should have done differently?
Brian Sack: The Fed could have perhaps defined its policy
reaction function for the balance sheet more clearly. Over theearlier QE programs, the Fed’s purchases moved in very large,
discrete steps. In retrospect, it might have been better to movein more moderate steps with more frequent adjustments toeconomic conditions, as that could have helped markets andthe public better understand how the Fed intended to set thispolicy instrument. When market participants are able tounderstand and anticipate central bank actions, monetary policy
tends to be more effective. The Fed ended up moving in that
direction during QE3, but it arguably could have done so sooner.
That said, I would note that the Fed was launching a new policy
instrument and that this innovation was taking place underchallenging circumstances. So, in my view, debating whether
the exact implementation of the tool was optimal is much lessimportant than the Fed’s overall decision to actively use thetool.
Allison Nathan: What will it mean for the economy and formarkets to put balance sheet expansion into reverse? Are
you concerned that normalization could prove disruptive?
Brian Sack: We should expect the portfolio balance effects thatI discussed earlier to reverse, which means that the term
premium should face some upward pressure. However, there
are several reasons to think that the adjustment will not besizable or disruptive. First, QE effects tend to occur when
expectations shift, not when the actual portfolio flows happen.
In this case, the Fed has already communicated the plan forshrinking its balance sheet, so a decent share of the impact
should be behind us. Second, the decline in asset holdings is
set to take place in a gradual and predictable manner, so theFed has successfully made this adjustment relatively “boring.”

Marina Grushin | marina.grushin@gs.com

David Groman | david.groman@gs.com

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And third, even once the Fed shrinks the balance sheet, themarket will know that QE is an ongoing, viable tool. The
prospect that the balance sheet is likely to increase again if
needed could act to hold down the term premium today.
Finally, I'd note that many fundamental factors are also holding
down the term premium, including low inflation expectations
and the beneficial correlation that Treasury securities have withrisky assets. If these factors were to shift in a manner that
amplified upward pressure on the term premium, the market
outcome could be more disruptive. But that would involve a
fairly meaningful shift—such as sharply higher inflation
expectations—which seems unlikely at the moment.
Allison Nathan: Could there be any unintended spillovers
from the interaction between Fed normalization and theECB’s eventual tapering of asset purchases?
Brian Sack: I do think there are important spillovers acrossglobal markets and that the global policy environment hashelped keep longer-term US interest rates low. If other central
banks adjust their balance sheets in the same direction, theincrease in supply and the associated effect on the term
premium could end up being larger than expected. That doesn'tmean we'll necessarily have an abrupt or disruptive market
outcome; it just means that whatever supply effect we wereanticipating would be turned up to some degree. Of course, at
this point, the ECB is only considering stopping the expansionof its asset holdings, not shrinking them, and the market isalready anticipating these policy shifts. So I don’t see a greatrisk of a disruptive outcome in the short run.
Allison Nathan: You are in favor of the Fed maintaining afairly large balance sheet in the longer run. Whatadvantages do you see to that approach?
Brian Sack: I published a proposal in 2014 with Joe Gagnon
saying that the Fed should operate a floor system with ameaningful role for the reverse repo facility, while maintaining alarge balance sheet. The idea was that this framework would
keep overnight market interest rates near the interest rate that
the Fed pays to financial institutions. We argued that such asystem would give the Fed effective control of interest rates
and would be operationally simpler than the prior framework. It
would also make the financial system more robust by helping
satiate the private sector’s substantial demand for short-term,risk-free assets. To date, our experience with the floor system
has been very positive, reflecting all of these advantages. I
expect the Fed to decide to maintain this type of system in thelonger run, and hence I doubt its balance sheet will ever fall
below $3tn in assets.
Allison Nathan: Some market observers take the opposite
view, arguing that the Fed should shrink its balance sheet
to pre-crisis levels based on concerns that the floor system
leaves the Fed with too large a footprint on the markets, orthat having a large balance sheet could compromise theFed’s independence, among other arguments. Is there meritto any of these concerns?
Brian Sack: I generally disagree with these views. I think thefootprint argument is exaggerated, since the balance sheet
simply transforms one type of government asset—a long-term
Treasury security—into another type of government asset—bank reserves or reverse repos. Many of the other arguments
in favor of a smaller balance sheet seem to be driven by
nostalgia for the way things used to be or by concerns about
political pressure from having a larger balance sheet. To me, itwould be a shame to allow any of those considerations to standin the way of arriving at the most effective, efficient, and robust
operating framework for the Fed.
Allison Nathan: You mentioned that the balance sheet—once considered an unconventional policy option—should
now be considered a viable tool...?

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Brian Sack: Yes. The Fed initially proceeded with asset
purchases in a very careful manner, which made sense giventhat we were in uncharted territory. But I think we’ve learned
that many of the potential costs associated with QE ended up
being more benign than initially feared by some observers.
What’s more, the Fed has now demonstrated control over thepolicy rate even with a large balance sheet.
Based on that experience, I think that the Fed should be more
comfortable using the balance sheet when it is unable toachieve adequate policy accommodation by lowering the federal
funds rate. In my view, there is a strong chance that the Fed
will have to turn to asset purchases again when the next
substantial economic downturn occurs, considering that theneutral level of the federal funds rate has fallen notably.
Allison Nathan: Would it make sense for the Fed topurchase a broader range of assets in the event of a future
downturn, as Fed Chair Janet Yellen suggested in a speechlast year?
Brian Sack: Purchases of Treasuries and agency-backed
securities—the primary assets that Congress has so far
authorized the Fed to buy—have the advantage of allowing theFed to affect the market price of interest rate risk without taking
on any credit risk. Purchasing a wider set of assets—as dosome other central banks—might enable the Fed to have alarger effect on financial conditions and promote fasterrecoveries. But it would also involve putting more taxpayer
money at risk and having an imprint on a wider set of risk
premiums in the market. So there is a tradeoff involved thatCongress would ultimately have to consider.
Allison Nathan: Economists like Larry Summers haveargued that Fed purchases of long-term government debt
would have been more effective at holding down the term
premium if the Treasury had not increased the maturity ofits debt issuance at the same time. Should there be morecommunication or coordination between the Fed and theTreasury? Or would that damage Fed independence?
Brian Sack: Debt management decisions can affect financial
conditions in the same way as QE; they both change the supplyof duration in the market. And decisions by debt managers canat times work at cross-purposes to QE decisions by the centralbank. We at the Fed were certainly aware of that throughout
the post-crisis period. However, I don't see a need for policy
coordination in most circumstances. The Treasury makes debt
management decisions with a set of goals that differ fromthose of the Fed; and the Fed can take those decisions as given
and set an appropriate path of QE around them.
However, there is clearly a need for communication. For
example, the market effects of Fed balance sheet runoff will
depend on what maturities the Treasury intends to issue toreplace those holdings. And the Treasury needs to have a senseof the Fed's runoff plan as it decides how to fund thegovernment. So certainly that type of communication shouldtake place, and I have a hard time believing that thosecommunications somehow impair the independence of the Fed,given that the Fed's mandate is clear.
Allison Nathan: What has been the most important lesson
from the Fed’s experience with QE? Is it applicable to othercentral banks still conducting asset purchases?
Brian Sack: We learned that asset purchases have clear
benefits and limited costs. I think a key lesson for all central
banks is that if they see QE as a viable policy instrument, it's
important to communicate that it will be used when thecircumstances call for it. That will allow markets to price central
bank actions further in advance and with greater accuracy,
which would only make the policy more effective.

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