Simon Potter: Gradual and predictable - reducing the size of the
Federal Reserve's balance sheet
Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the Federal
Reserve Bank of New York, at the SUERF - The European Money and Finance Forum
Conference "Globalisation Dynamics - EU and US perspectives", New York City, 11 October
2017.
* * *
1
Thank you very much. I appreciate the invitation to speak to you as part of today's SUERF
conference on "Globalization Dynamics: EU and US Perspectives." With events like these, the
SUERF aims to foster an active network between professional economists, financial
2
practitioners, central bankers and supervisors. Ongoing dialogue between these groups is
important to the efficient and effective implementation of monetary policy, and I am glad to have
the opportunity to make a small contribution to that dialogue.
Just a few weeks ago, the Federal Open Market Committee (FOMC) announced that it would
begin to passively reduce the size of its securities portfolio. This announcement marks the
beginning of a multiyear effort to bring the Federal Reserve's balance sheet to its longer-run
size. In my remarks today, I'd like to offer my views on this policy from a financial markets
perspective.
The message I'd like to leave you with today is one of confidence. I am confident that the
FOMC's plan will reduce the size of the portfolio in a gradual and predictable, "no surprises"
manner. I am confident that the FOMC's plan will promote good market functioning in the
Treasury and agency mortgage-backed securities markets as the portfolio declines, and that it
will not prove disruptive to the U.S. mortgage market or the U.S. Treasury's debt management
program. And I am also confident that the plan's design, and the FOMC's clear communication
prior to the plan's implementation, will mitigate the risk of sharp or outsized asset price reactions
to the decline in the portfolio's size over time.
I want to expand on this last point. We cannot and should not prevent Treasury and MBS prices
from reacting to relevant economic and financial developments, or indeed from gradually moving
over time in response to the progressive decline in the size of the Federal Reserve's holdings
and consequent increase in the amount of securities held by the private sector. In fact, we
actively want asset prices to respond appropriately and fully to economic and financial news.
Over the coming years, such news could span a wide variety of topics, such as central bank
policy in this country and abroad, the ongoing debate over fiscal policy, and the evolution of
expectations for the longer-run neutral rate of interest. That said, we do seek to mitigate the risk
that our operational actions contribute to unnecessary surprise, disruption, or volatility. I am
confident that the FOMC's plan appropriately manages this risk.
Now, confidence doesn't mean certainty: there is always a risk that events could unfold differently
from expectations. In particular, central banks have had little directly relevant past experience
with the impact of such a reduction in holdings of domestic securities and in reserves. One
relevant experience, of course, was the 2013 "taper tantrum," which shows that markets can
have outsized reactions to changes in balance sheet policy even before they happen. Moreover,
experience with asset purchase programs, both here and abroad, clearly demonstrates that
market volatility can ensue from balance sheet policy changes that market participants perceive
as surprising, unclear, or rapid. All of this indicates to me that, at policy turning points like these,
central banks should carefully and clearly communicate their intentions, provide as much
transparency as possible, and make transitions in policy implementation as slowly as overall
macroeconomic policy objectives permit.
Policymakers have made it clear that balance sheet normalization is intended to operate in the
background, and that the bar is high to making changes to the FOMC's normalization plan. That
said, the future is uncertain, and as a result the Desk will maintain an appropriate set of
capacities should the FOMC deem something different be required to promote the Federal
Reserve's objectives. We will also continue to gather market intelligence, including through
surveys of primary dealers and market participants and through a robust set of statistical data
collections, to further policymakers' understanding of market participants' expectations for the
balance sheet and to monitor market functioning.
The rest of my speech will go as follows. First, I'll provide an in-a-nutshell summary of the
structure of the Federal Reserve's balance sheet. Then, I will discuss why it is important that the
decline in the balance sheet be gradual and predictable, and explain how the FOMC's plan
provides this gradualism and predictability. I will then talk briefly about how the Federal Reserve
is ensuring it is operationally prepared for unexpected developments. And then I'll conclude on a
slightly different note: I'll offer my thoughts on why financial markets seem to have reacted much
more calmly to balance sheet news this year than they did during the 2013 "taper tantrum"
period.
As always, these views are mine alone and do not necessarily reflect those of the New York Fed
or the Federal Reserve System.
The Fed's balance sheet, in a nutshell
Let's begin by reviewing, at a high level, where the Fed's balance sheet is today, and where it is
likely to go in the coming years. Although many things about monetary policy are very complex,
the basic structure of the balance sheet is actually fairly simple, as is the program of balance
sheet normalization.
Panel 1 shows a summary of the Fed's assets and liabilities, as they are today. Substantially all
3
of the $4.5 trillion of assets consist of Treasuries and agency MBS. On the other side of the
balance sheet, the Federal Reserve has three main categories of liabilities: $2.6 trillion of bank
reserves and other deposits, $1.5 trillion of paper currency, and about $400 billion of reverse
repos.
Before the crisis, the balance sheet was much smaller. It reached its present size as a result of
the FOMC's large-scale asset purchase programs, which were undertaken to support the
economic recovery by easing financial conditions to a greater extent than could be achieved
solely through reducing the federal funds rate, as the FOMC's ability to provide further monetary
accommodation through this instrument was limited by the zero lower bound on interest rates.
These asset purchases had two effects on the balance sheet: they increased the size of the
asset portfolio, and they equally increased the size of the Federal Reserve's liabilities, largely
4
through growing the stock of bank reserves.
In addition to being larger than it was before, the balance sheet has a significantly different
composition than before the crisis. On the asset side, the most important change has been the
addition of agency MBS.
For many years, the FOMC has made it clear that it did not intend for the balance sheet to
5
remain at this size forever. Instead, through its statements and its Policy Normalization
Principles and Plans, it has indicated its intention that the Federal Reserve will, in the longer run,
hold no more securities than necessary to implement monetary policy efficiently and effectively,
and that in the longer run it will hold primarily Treasury securities. Starting in its December 2015
statement, the FOMC also indicated that it anticipated continuing reinvestment until normalization
of the level of the federal funds rate was well under way. The FOMC also indicated, starting in its
September 2014 Policy Normalization Principles and Plans, that it intended to reduce the Federal
Reserve's securities holdings in a gradual and predictable manner primarily by ceasing to
reinvest repayments of principal on its securities holdings.
The FOMC's strategy of waiting to begin normalizing the balance sheet until normalization of the
federal funds rate was well under way had several advantages. Most importantly, it reduced the
likelihood that an unexpected adverse shock to the economy not long after the start of policy
tightening would have necessitated a return to the zero lower bound on the federal funds rate and
potentially a reversal in balance sheet normalization. Instead, the FOMC's approach promotes
the use of the federal funds rate as the active monetary policy instrument, an instrument with
which the FOMC has much greater experience. In addition, delaying balance sheet
normalization allowed the FOMC to meaningfully assess the efficacy of its tools to control
shortterm interest rates with a large balance sheet, and thereby judge how patient it could afford to be
6
in reducing the balance sheet to its longer-run level.
From an accounting perspective, the decline in the balance sheet will, at a high level, resemble a
mirror image of its earlier increase. We should of course expect to see the amount of assets
decline, and this will be matched by a decline in the overall stock of liabilities. Most of this decline
in liabilities will likely take place as a decline in bank reserves. The size of the balance sheet will
be "normalized," in Federal Reserve parlance, when the FOMC judges that the Federal Reserve
is holding no more securities than necessary to implement monetary policy efficiently and
effectively.
At that point, the size of the balance sheet might well be "normalized," but its composition will
probably not be. Panel 2 shows a stylized summary presentation of how the Federal Reserve's
assets and liabilities might look when the size of the balance sheet is normalized, drawn from the
"median scenario" included in the July 2017 update to our annual report, "Open Market
Operations During 2016." This presentation is largely based on the median of market
participants' surveyed expectations collected in June, along with some staff modeling to fill in the
details, and as such is not an FOMC projection or forecast. That said, it provides a useful way to
illustrate my point.
On the asset side, in this median scenario, the portfolio would still contain a substantial allocation
to agency MBS at the time of normalization, even though the FOMC has, as I noted earlier,
indicated a preference to hold primarily Treasury securities in the longer run. The maturity
composition of the Treasury portfolio, not shown in the figure, would be different from what it was
before the financial crisis. On the liability side, at normalization, non-reserve liabilities in the
median scenario would be considerably larger than they were pre-crisis. Some of the growth in
the reverse repo programs we have observed since the crisis might be a second-round effect
stemming from the growth in reserves, and therefore some decline in this category is possible
as the overall balance sheet size declines. However, my overall read is that much of the
increased demand for non-reserve liabilities, particularly currency in circulation, is likely to be
7
persistent past normalization, and indeed demand for reserves is also likely to be higher.
But what is the longer-run appropriate size for the balance sheet? Other than the qualitative
guidance I mentioned earlier, and an expectation that the level of reserve balances will be
appreciably below that seen in recent years but larger than before the financial crisis, the FOMC
8
has not specified how large the balance sheet should be. My colleague Lorie Logan spoke
recently on the many technical drivers of this level, which include the mode of policy
implementation that the FOMC chooses in the longer run, possible increases in recent years in
the financial system's demand for reserves and Federal Reserve reverse repo liabilities owing to
new financial regulations and other factors, and the long-term evolution of demand for paper
9
currency.
Considerations in reducing the balance sheet size
theory, reducing the size of the balance sheet is quite simple. There are two ways to go about
10
it.In One approach is to simply let securities holdings mature. Principal matures on the Fed's
securities holdings all the time: Treasury bonds mature at specified dates, and agency MBS
11
principal is repaid over time as home loans are paid back. For the past several years, the
securities portfolio has been maintained at a steady level by reinvesting these principal
12
repayments. This activity can be reduced or stopped. A second approach is to simply sell
securities on the open market, using a similar procedure to the way the securities were
purchased to begin with.
Either way, the securities end up back in private hands. This is obvious in the case of sales.
When we don't reinvest principal repayments on Treasuries, the securities the Federal Reserve
would otherwise have bought end up in private hands instead. And when we don't reinvest
agency MBS principal repayments, this means that any new mortgage that was taken out to fund
those repayments ends up being sold to private investors. While the mechanism varies, the end
result, in theory, is largely the same.
So how should the Fed implement a reduction in the balance sheet size? The approach should
underscore that the balance sheet will be reduced in a way that is gradual and predictable, so as
to credibly assure market participants that the balance sheet will decline in a way that avoids
surprise, disruption, or volatility. As part of this, it should be simple, and easy to communicate to
the public.
13
The FOMC's plan for normalizing the balance sheet does exactly this. It decreases principal
reinvestment, an approach which provides for an appropriate pace of reduction in the balance
sheet and is quite straightforward to communicate. It accomplishes this by reinvesting principal
14
maturities only to the extent that they exceed gradually increasing caps. For Treasuries, the
cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month
intervals over 12 months until it reaches $30 billion per month. Agencies follow a similar pattern,
starting at $4 billion and rising in three-month steps to $20 billion. The FOMC also indicated that
it anticipates that these caps will remain in place once they reach their respective maximums.
Let me spend a few minutes discussing the importance of gradualism and predictability, and how
the FOMC's plan achieves these things.
Gradualism
To examine the importance of gradualism, we will need to open, once again, the theoretical
15
debate about "stock" and "flow" effects of central bank asset purchases and sales. Under the
"stock view," transitions in the pace of central banks' asset flows should have little direct effect
on asset prices. Instead, what matters to asset prices is the present and expected future stock
of assets the central bank holds, or is anticipated to hold. The "flow view" suggests instead that
the effect on asset prices relates to the pace at which assets are being added or removed from
the balance sheet at that time.
Many speeches have been given, and journal articles published, about the relative importance of
these effects with respect to their impact on financial conditions and the broader economy, a
16
topic that I do not intend to wade into today. Instead, I think it's important to make a few points
on "flow effects" relevant to policy implementation, and in particular related to possible "flow
effects" associated with an overly rapid pace.
Overly fast flows of securities into private hands can be disruptive to market functioning. In
particular, there is evidence that the agency MBS market, due to the nature of its trading
conventions, is prone to dislocation when market participants expect large transitions in central
17
bank agency MBS flows. Such concerns can be self-fulfilling: if market participants are
concerned that an abrupt shift in flow might be disruptive, they might, for example, withdraw from
liquidity provision. An overly fast redemption flow of Treasuries could also create challenges in
the government's management of public debt auctions and result in communications
18
challenges.
A sustained portfolio runoff at an overly fast pace could also shrink the balance sheet so quickly
that it impacts other aspects of monetary policy implementation. Rapid portfolio declines could
have unforeseen impacts on overnight money markets, for example by creating significant shifts
in dealers' demand for overnight repo financing. We have seen such impacts in the past. During
the Maturity Extension Program, the Federal Reserve sold substantial amounts of shorter-dated
Treasuries. Some of these securities accumulated in dealers' inventories, and secured
financing rates rose a bit as dealers sought to finance these holdings. This sort of volatility did
not, and would not now, pose a major problem to markets or policy implementation, but it is
something worth avoiding if possible. Rapid portfolio runoff could also make it more likely that
bank reserves become scarce unexpectedly or more quickly than policymakers had anticipated.
Finally, overly fast portfolio runoff could introduce undesired noise into financial conditions.
Policymakers have indicated that they want the portfolio's size to decline "in the background,"
and that the federal funds rate be the primary instrument of monetary policy. Rapid portfolio
runoff could lead market participants to overestimate the total decline that will occur in the
Federal Reserve's securities holdings, and thereby accelerate the rise in term or mortgage risk
premia associated with balance sheet normalization. This could complicate policymakers'
economic forecasting and make it more challenging to determine and communicate the
appropriate monetary policy stance.
The FOMC's plan addresses these concerns about gradualism in two ways. First, it begins at a
low rate of redemption, increases this slowly and in small amounts, and then continues at a
specified maximal rate of runoff. These amounts should result in transitions that are within the
market's capability to absorb. Second, because the plan explicitly and numerically
communicated the FOMC's plans, it should promote stability in market estimates for the future
size of the balance sheet, and confidence that the FOMC will not unintentionally create market
stress.
Predictability
The second goal is to provide the public with a degree of certainty that, as the Federal Reserve
reduces reinvestment, the market will not be asked to absorb securities at a speed that
unexpectedly changes in a significant way. I've already discussed why it is important that the
flow of securities back into the market be gradual. Predictability is about ensuring that the flow is
gradual across economic scenarios, including scenarios that are quite different from our central
forecast. Achieving this predictability is complicated by uncertainty about agency MBS principal
repayments, an issue I'll summarize briefly.
To an extent, mortgage payoffs are driven by the white noise of life, such as homeowners selling
their homes as they find new jobs in different areas of the country, have children, or retire, and in
the process pay off the mortgage on their old house. There is some uncertainty about how
social and demographic factors like these will impact the housing market over the long term, and
this therefore creates uncertainty in long-term MBS prepayment forecasts. Over the short term,
however, by far the greatest source of aggregate uncertainty in mortgage principal repayments
relates to refinancing, the process by which homeowners get a new mortgage with a better
interest rate, and pay off their old one in the process. Refinancing results in existing agency
MBS, containing the old higher-rate loans, being paid off more quickly, along with greater
issuance of newly-minted agency MBS containing the new, lower-rate loans.
Homeowners are incentivized to refinance when mortgage rates decline below the rate on their
current loan. In contrast, most market participants expect longer-term interest rates, including
primary mortgage rates, to rise over policy normalization, and that therefore mortgage
refinancing activity will be modest. As a result, most expect mortgage principal repayments to
run below the level of the redemption cap set by the FOMC. Projections for these repayments,
drawn from the July 2017 update to our annual report that I discussed earlier, are shown in
lefthand side of Panel 3.
The benefit of the cap, even though it is unlikely to bind, is that it limits the amount of variation in
the pace at which securities, and particularly mortgages, will flow back into private hands. Recall
that the left-hand figure in Panel 3 is based on rising interest rates over an ongoing economic
expansion. For comparison, the right-hand figure in Panel 3 shows the projected MBS principal
repayments for a scenario in which interest rates come in two percentage points below market
participants' expectations. In this scenario, the cap operates to constrain the flow of securities
into the market. While such a lower-rate outcome is not a central expectation, it is certainly
possible.
By providing market participants some certainty that the pace of balance sheet decline will be
gradual across economic scenarios, this plan should help mitigate the risk of unexpectedly sharp
shifts in asset prices, liquidity, or market functioning should markets begin to put greater weight
on lower interest rate scenarios. Indeed, by promoting greater confidence in the stability and
liquidity of the Treasury and agency MBS markets across economic outcomes, the FOMC's plan
should result in lower risk and liquidity premia on these assets relative to normalization plans that
do not promote such confidence.
The importance of predictability is underscored when one considers that in recent years, adverse
economic shocks have generally been associated with sharp falls in longer-term interest rates.
Such declines would tend to bring about faster MBS repayments and, if the outflow from the
Federal Reserve's portfolio were not constrained by a cap, an unforeseen tightening effect on
financial conditions, amplifying the adverse shock.
Prepared for the unexpected
While I am confident that the FOMC's plan will work well, there's always the risk that events
unfold differently than expected. In my view, we best prepare for the unexpected in two ways: we
need to be operationally ready to change course when needed, and we need to remain
analytically focused so we know when to recommend to policymakers that they do so.
So long as the plan I've described to you proceeds uninterrupted and as expected toward
normalization, it is likely that policymakers' operational demands on the Desk will be considerably
lighter than they have been over the last decade. However, it is possible that unexpected
developments in the economy may require a change of plans. For example, the FOMC has
made it clear in its addendum to the Policy Normalization Principles and Plans that it stands
ready to resume reinvestment if a material deterioration in the economic outlook were to warrant
a sizable reduction in the federal funds rate. The FOMC also indicated that it 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. You may recall that Chair Yellen reiterated
these points in her press conference following last month's FOMC meeting. Likewise, while the
principles and plans do not indicate an expected role for asset sales in portfolio normalization,
except in that limited sales might be warranted in the longer run to reduce or eliminate residual
holdings of agency MBS, the operational capability remains, even though we do not expect it will
be needed.
Unexpected operational demands could also emerge from technical developments within the
Treasury and agency MBS markets. Even though it is shrinking, the Federal Reserve's portfolio
is and will remain large, and market participants will look to the Federal Reserve to lend out on a
collateralized basis some of its holdings from time to time in order to facilitate settlement, as is
done by most other large fixed-income investors. The Desk does this in the Treasury market via
its decades-old securities lending program, and performs an analogous role in the agency MBS
market by conducting so-called "dollar roll" and coupon swap transactions as necessary to
facilitate settlement of the Federal Reserve's agency MBS transactions. The Desk always
welcomes discussion with market participants on ways in which it can support market
19
functioning.
Preventing tantrums
I noted earlier that my confidence that the FOMC's plan for balance sheet normalization was in
part due to its clear communication: the gradual and predictable nature of the balance sheet
decline should help ensure that market participants' expectations remain well aligned with what
eventually transpires. In my view, a "trust, but verify" approach is called for to ensure that this
confidence is appropriate. While I trust that the program design will keep expectations for the
portfolio realistic, I believe that a robust analytical mechanism to verify this, underpinned through
continuous market monitoring, broad-based surveys of primary dealers and market participants,
and a diverse suite of statistical data collections, will help ensure that policymakers can detect
early and respond promptly to situations where market participants expect the portfolio to evolve
significantly differently from policymakers' expectations.
The idea is simple: keeping these two sets of expectations aligned should help prevent the risk
that they get very far apart, an adjustment has to take place, and there is large move in asset
prices. But the experience of the 2013 "taper tantrum," when asset prices moved sharply and
unexpectedly following former Chairman Bernanke's announcement of an eventual cessation in
asset purchases, poses some questions about doing this in practice. What might have caused
the taper tantrum, and why have financial markets been so much more stable in comparison this
time around?
First, there are limitations to what one can learn from market intelligence, whether it is done with
a survey, through analytical modeling, or market monitoring. The Federal Reserve's market
intelligence-gathering is among the best there is when it comes to breadth, detail, and rigor. For
example, we are the only central bank that conducts market surveys directly on balance sheet
policy. That said, the 2013 taper tantrum would not have been anticipated based on market
surveys conducted at the time, as the median surveyed market participants' projection for the
end of asset purchases was similar to the plan Chairman Bernanke outlined in his
20
announcement. In his book "The Courage to Act: A Memoir of the Crisis and Its Aftermath,"
Bernanke attributed the failure of surveys to anticipate the taper tantrum to the fact that, at the
time, they reached only primary dealer economists, a homogenous and insular group that he felt
21
was unrepresentative of investors generally.
I think there is truth to this, but I wonder if there is more to the story. We now survey a broad
community of investors in addition to the primary dealers in a bid to gather a more diverse and
inclusive perspective, partly in response to this concern. While this makes our surveys more
robust, since we started doing this we haven't observed large differences in median responses
between the dealers and the buy-side community. As an example, Panel 4 shows a time series
of the expected level of the federal funds rate at the end of 2017 for dealers and for buy-side
22
firms; these two track each other closely. On the other hand, both the dealers and buy-side
community responses exhibit substantial dispersion around these medians. One explanation for
the adverse reactions to Federal Reserve communications in the spring of 2013 is that the
marginal investor is not the same as the median respondent to our surveys.
Looking past the survey, I think there are a few key factors that differ between now and 2013 that
might explain why the market reaction has been so much calmer this time. The macroeconomic
environment is markedly better. Market participants have a better sense for the FOMC's
approach to increasing the federal funds rate, and there is much greater clarity on the respective
roles of the balance sheet and the overnight policy rate. The normalization plan is more clearly
gradual and predictable. And the balance sheet news this time around may just not have been all
that surprising. I'll talk briefly about each of these.
One important difference between now and 2013 is that the labor market is very healthy, with
unemployment close to levels most associate with full employment. Recall that FOMC
statements around the time of the taper tantrum stated that asset purchases would continue
"until the outlook for the labor market has improved substantially in the context of price stability,"
and it is possible that many market participants took the signal from an impending taper that the
FOMC was less committed to the goal of a substantial improvement in the labor market than
they had thought. Not only could this have affected some investors' expectations for the balance
sheet going forward, but it could have also affected views on the FOMC's other policy tool: the
23
overnight interest rate.
A related possibility is that in the current situation expectations for a very gradual program of
increases in the federal funds rate are relatively well entrenched, with liftoff more than a year and
a half behind us. In 2013 market participants were focused on policies that would add more
accommodation. Under the "recruitment effect" proposed by former Governor Jeremy Stein and
Sam Hanson of Harvard Business School, yield-oriented investors react to lower short-term
rates by "reaching for yield" into longer-dated maturities, and reverse this effect when short-term
24
rates rise. These effects can be even larger when balance sheet policies are in active use. As
a result, a shock to expectations of the central bank's reaction function can lead to outsized
movements in longer-term rates. The FOMC's current approach entails a much clearer
delineation of the roles of the federal funds rate and the balance sheet, breaking the link that
appeared in the spring of 2013: the association between a reduction in the balance sheet and a
shock to expectations for the federal funds rate. As shown on Panel 5, even with the active
discussion of balance sheet normalization in the March and May 2017 FOMC meeting minutes,
market participants attributed very little of the movement in longer-term rates to communication
from the FOMC regarding potential changes in their reinvestment policy.
It's also possible that it is especially important for the FOMC to act in a gradual and predictable
way at times when investor response to Federal Reserve announcements might not be expected
to follow predictions that come from economic models that assume rationality, perfect
information, expectations for continuously optimal policymaking, and so on. George Soros's
theory of reflexivity might be instructive here. Soros's framework is based on two propositions:
fallibility, which means that market participants' views of the world can never perfectly
correspond to the actual state of affairs; and reflexivity, which means that these imperfect views
25
can influence the situation through the actions of those who hold those views. In other words,
perception might not correspond to reality, but perception can influence reality. Taking this to the
monetary policy context, expectations for disruption or volatility from an substantial change in the
Federal Reserve's operational posture, even if totally unfounded, could bring about disruption, as
the holders of those expectations act to protect themselves or profit from what they believe is
likely to come. The solution is to try to avoid generating such expectations for disruption to begin
with, by acting gradually and predictably.
Another potential explanation for the relative stability of longer-term rates this time around is that
balance sheet news this year, taken together, just hasn't been all that surprising to market
participants. Panel 6 shows market participants' expectation for the level of the federal funds
rate that would prevail when the reinvestment policy first changes, as well as expectation