Wesbury’s Monday Morning Outlook: WSJ Leak: Fed May Shrink Balance Sheet
Date: April 3, 2017
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If you read us regularly, and we hope you do, you know
that we write each week about a topic we think is both
important and timely. Last week, we were either clairvoyant, or
extremely persuasive.
We argued that unless and until the Federal Reserve
reduced the size of its balance sheet (and unwound quantitative
easing), it would not be in control of inflation. Rate hikes alone
wouldn’t be effective. Last week, it didn’t seem like the Fed
shared our concern. But, this week is a different story.
Last week, all anyone talked about was whether the Fed
would hike interest rates two or three more times in 2017, after
hiking them by a quarter-point in mid-March. As we argued, as
long as there are excess reserves in the financial system, higher
inflation will remain a threat, even if the Fed hiked rates.
This week the world has changed. Fed Chair Janet Yellen
apparently allowed a leak to the Wall Street Journal, published
on March 31st
, suggesting the Fed understands the problem.
The Fed is taking off the table the idea there might be four rate
hikes this year, but is putting on the table the idea that it will
eventually pause on rate hikes and start reducing the size of its
balance sheet as the normalization process continues.
At this point, the Fed is being slow and cautious and only
planning on doing one thing at a time – rate hikes or bond sales.
Later, it might do both at the same time.
So what should investors expect? Before the leak, it
looked like the Fed would raise rates two or three more times
this year, once in June and another time in either September or
December, with some possibility of hiking rates in both
September and December.
Now we think the Fed will raise rates in June and
September and then take the following six months to start the
“Great Unwinding” of the balance sheet. To begin, the Fed will
take baby steps. It’s not outright and actively going into the
financial markets selling bonds from its balance sheet. Instead,
it will take a portion (but not all) of maturing principal
payments on its bond portfolio (Treasury or mortgage-backed
securities) and not reinvest them into new securities, instead
using that portion to extinguish excess reserves.
This cautious approach will not disrupt the bond market,
but it will allow inflation to become more entrenched. As we
argued last week, as long as excess reserves exist, rate hikes
will make it more profitable for banks to lend those excess
reserves. This expands the money supply and creates inflation.
In other words, the Fed has a long way to go. But like any
government entity, unwinding its actions always proceeds at a
much slower pace than the speed of its interference. This is
why monetary policy is almost always biased toward inflation.
What this means for the economy and financial markets is
that the Fed is highly unlikely to become a drag on growth
anytime in the near future. And since the number one cause of
recession is an excessively tight Fed, we think investors should
watch this process carefully, but not be alarmed by it.

Rogan & Associates

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