More pressure on central banks’ balance sheet reduction

 It assumes that the Fed’s security holdings will be reduced from over USD8tr to just below USD6tr through to 2025

It seems clear that the intention is to use interest rate hikes as be the primary tool while balance sheet reduction will work away in the background, almost unnoticed. But whether this is how things will play out in practice. It is early days yet for central bank balance sheet policy. The Fed will only start to run down its balance sheet from next month while others like the ECB and BoE have no such plans just yet. Instead, the early stages of the policy-tightening process has, and will be, marked by interest rate increases.

On rates, banks have to decide whether to go hard and fast, at the risk of overdoing it and tipping their economies into recession. Or taking things easy and hoping that inflation can be controlled with more modest rate hikes. Reserve Bank of New Zealand Governor Orr argued after this week’s 50-bps hike that its least regret is to do too much too soon on rates.

In other words, it wants to go hard and fast, even if this means that it has to reverse course in the future. Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks this is the right way to go, but it is not clear that all central banks are singing from this particular song-sheet. Of course, many other central banks like the Fed, ECB and BoE have another ace up their sleeves to tighten policy, which is quantitative tightening.

However, there is little sign that they are using it as plans for balance sheet reduction seem modest in the US and, so far, nonexistent for most others. In the US, the Fed has made much of the fact that its balance sheet rundown will be more rapid than its last such action between 2017 and 2019. But the Bank is still very aware that it had trouble with its policy in 2019 as balance sheet reduction drained liquidity too much and the Fed had to act to supply cash back to the market via bill purchases. This reflects the fact that the risks associated with balance sheet reduction occur at both the start of the process and the end.

The risks at the start are that the “announcement” effect of the Fed’s future actions will lead to sharply higher yields as the market rapidly discounts the extra treasury supply that is to come. At the end of the process, the risks shift to funding, as we saw in 2019, when liquidity strains started to emerge as the Fed’s balance sheet was taken back down to around USD3.75tr from USD4.5tr before the balance sheet runoff started.

So far in the current runoff process, the announcement effect has seen higher rates, although that might be down to the Ukraine crisis and the surge in energy prices. But what about the end of the process and the funding strains that could emerge? On this we can use the assumptions recently made by the Federal Reserve Bank of New York. It assumes that the Fed’s security holdings will be reduced from over USD8tr to just below USD6tr through to 2025 and will then rise in line with the public’s demand for cash, as was the case before the Fed started to mess with the balance sheet in 2008. The USD6tr level is put at around 22% of GDP, which is above the 17.2% low seen in 2019 – when the market started to experience liquidity problems.

In other words, these estimates assume that, while the Fed might reduce the balance sheet at a faster pace than 2017-19, its end point will be kinder to the banks. That might make sense given the 2017-19 experience, but whether it makes sense when the Fed is fighting such high inflation is questionable.

“Fed would have to be more aggressive on rates than it is currently suggesting and also think that it might have to be more aggressive on balance sheet reduction as well. The same holds in our opinion for other central banks. In fact, it might even be wise to put more emphasis on balance sheet reduction than rate hikes. This is because balance sheet reduction is less obvious and less public and could help to avoid creating the extremely negative psyche amongst consumers and businesses (from lifting policy rates) that could tip economies into recessions that are deeper than may be necessary to rid countries of surging prices”, Mr. Steve Barrow said.