Debate continued on the evolution of the Fed’s balance sheet. Kaplan reiterated the general stance of the FOMC, which wants “the interest rate to be the primary vehicle, the primary tool we use for monetary policy.” He observed that “actions on the balance sheet have some effect, but I think we want to center our monetary policy work on using the interest rate.”
Williams noted that normalization of the balance sheet could begin before the FOMC reaches a decision on the balance sheets’ ultimate configuration: “We could start a normalization of the balance sheet and then make a decision, do we stop at X or Y,” adding that it could be in the next year or so. Harker had a similar mindset: “Possibly by the end of this year or the beginning of next year would be an appropriate time to stop reinvesting (maturing assets), but that’s all dependent on how the economy evolves between now and then.” Mester expressed her comfort with amending the reinvestment policy during this year, while Powell preferred to wait until ”the economy has significant momentum” to shrink the balance sheet. Dudley was open to changing the current reinvestment policy this year or next, and referred to market expectations of a funds rate threshold of one to two percent: “I think generally if you talk to people in the market they think that’s going to start sometime with the federal funds rate between 1 and 2 percent.” Dudley cited the necessity for some distance from the zero lower bound before embarking on balance sheet normalization: “We wanted to have a little bit of room off zero before we started doing something with the balance sheet.”
There was some sense that drawdown of the balance sheet, like rate hikes, represented removal of policy accommodation. Williams argued that it would perform “lot of work for the committee in terms of removing accommodation.” He warned that the FOMC should be cautious about the tightening effect of balance sheet reduction: “We do have to be careful that as we, once the balance sheet starts to shrink down to a lower level, that we realize that’s kind of like rate hikes happening in the background.” Dudley’s remarks underscored the potential substitutability of rate hikes and balance sheet runoff, arguing that they were “two different, yet related, ways of removing” accommodation. He went as far as saying “If we start to normalize the balance sheet, that’s a substitute for short-term rate hikes…we might actually decide at the same time to take a little pause in terms of raising short-term interest rates.” Harker echoed this logic: “We have to balance this off the path of the fed funds rate. As we cease reinvestment it will remove some accommodation. These two things are related.” He shared our view that tapering the end of reinvestment would be a better course of action than an abrupt end. Harker’s view was similar: “I don’t necessarily see some abrupt cutoff and then we’re done.”
Dudley also revealed that he did not see a distinction between ending reinvestment of both MBS and Treasuries or of MBS only, options that have been floated outside the Fed: “I don’t think there is a strong need to differentiate between mortgages and Treasuries [for ending reinvestments.]” In contrast, Harker held a view more consistent with that expressed in recent FOMC minutes: “I would rather see us be much more heavily weighted on Treasuries than MBS…I’m not necessarily convinced yet that we should completely get out of MBS, but clearly we want a Treasury-heavy portfolio going forward.”
Policymakers agreed that balance sheet normalization would initially be a change in reinvestment policy rather than outright sales: “In the near term, it’s just passive run-off of the portfolio, not active asset sales.” Evans’ view was consistent with Dudley’s: “We’ll get to the point where we’re going to want to start reducing size of the balance sheet, and we should convey a sense that it’s going to run off in a pretty disciplined, well-understood, perhaps controlled fashion.” Dudley was “not that worried that the markets are going to react to changes to our balance sheet in a very violent way because it’s already factored in.”