Eleven years after it started buying trillions of dollars of mortgage bonds in an emergency campaign to prevent bloated banks from failing, the Federal Reserve still has “some normalizing to do” — but it’s still not ready to sell those bonds and rush back to its smaller, pre-recession form, Federal Reserve Bank of Philadelphia president Pat Harker told an international crowd of bank regulators and bankers Monday in London.
“Our aim is for the [Fed’s] balance sheet to consist primarily of Treasury securities," but "that is not its current composition, and won’t be for some time, with [mortgage-backed securities] still accounting for 40 percent of our total asset holdings,” Harker acknowledged in prepared remarks to the Official Monetary and Financial Institutions Forum, released at 10:30 a.m. Eastern time.
While President Donald Trump has urged a continued policy of cheap money to keep businesses and consumers borrowing, the Fed has felt pressure from conservative economists to boost interest rates and cut back its swollen balance sheet so it will be better able to fight the next recession.
The Fed has decided not to rock the boat: Even if the U.S. economy slows down, as some investors worry it will this year or next, “the balance sheet will not see any drastic change in the near future," Harker underlined.
Bank bonds parked at the Fed still total about $1.6 trillion — “$1.2 trillion less than the peak of $2.8 trillion, back in 2014, and close to $600 billion less than when we started unwinding,” but still more than triple the precrisis Fed, Harker noted.
The Fed has shrunk enough for now, and has no intention of going all the way back to its more modest profile of the early 2000s, Harker made clear: “We intend to end the balance sheet runoff in September, resuming the reinvestment of all principal payments. Paydowns from [mortgage-backed securities, up to] $20 billion per month, will be reinvested into [U.S. Treasury bonds], which is consistent with our long-standing plans to hold primarily Treasuries in our portfolio.” That will still leave Fed reserves “above the level needed to efficiently and effectively implement monetary policy.”
Harker amplified and put in context remarks by Fed Chairman Jerome Powell, a Trump appointee, last week. Powell on Friday said it is more likely the Fed will stop shrinking its balance sheet now that it has halted a trend of boosting interest rates, noted Ryan Sweet, head of monetary policy research at Moody’s Analytics.
“The debate about the policy response to the next recession is good to have now. The Fed will have to think outside the box to address the next recession because they won’t have as much fire power, with regards to cutting interest rates, as in the past,” added Sweet.
Though Trump has urged the Fed to stop boosting rates, which he says will slow the economy, Powell has said the Fed is moving away from higher rates for economic, not political, reasons.
This doesn’t mean the Fed has given up on fighting a future recession. The central bank is still “prepared to alter the size and composition of the balance sheet if future economic conditions” call for the Fed to fight a slowdown, Harker added. But the Fed does not plan to go there “for a time" — more likely “we will see a very — and I do stress ‘very’ — gradual decrease in average reserves, as currency and other non-reserve liabilities grow” but no more bonds are purchased.
The Fed’s plan is lacking in details, says economist David R. Kotok, chairman and chief executive of Cumberland Advisers, Sarasota, Fla. Harker “doesn’t say what economic conditions” would trigger changes to the Fed’s new slow-shrinking policy. “He doesn’t say how to estimate” the Fed’s long-term balance sheet targets, or what economic forces will change those targets and the Fed’s future efforts to boost the economy, Kotok concluded
Harker said economists at the Philly Fed, led by Roc Armenter, had conducted analyses that support “this slow and steady approach," which he called “the safer option” and one that reduces “uncertainty” about the Fed’s intentions, making it more “predictable.”
And he warned against “misinterpreting” the Federal Reserve Open Market Committee’s intentions based on a few keywords in its statements, which reporters and economists sometimes seem to regard as oracular revelations.
For example, "we often refer to the FOMC’s ‘tool kit’ when discussing policy options. Balance sheet policy certainly remains an option, but we’ve put it back in the toolbox, and stored it in the basement — within arm’s reach, but out of sight for now,” Harker added.
Stressing that he was speaking for himself and not the Fed as a whole, Harker predicted GDP growth “a bit above 2 percent for this year, returning to trend of around 2 percent sometime in 2020” as a result of the U.S.'s aging population, slow-growing workforce and “lower productivity growth.”
Consumers remain the primary driver of economic growth, and Harker noted that “household spending continues at a strong, sustained pace.”
But business, to the contrary, is reporting " an increase in uncertainty and a decrease in confidence. … The investment outlook is not quite as rosy as last year" though the long Obama-Trump-era expansion continues, with the economy reporting nearly 200,000 new jobs a month and inflation at around 2 percent.