I always enjoy watching coverage of Ben Bernanke’s visits to Capitol Hill. In particular, the question and answer sessions are consistently of interest to me because they provide the opportunity to listen to Bernanke speak on a wide variety of topics. Generally, I think the Chairman does a decent job navigating some of the traps Congressional members attempt to set in terms of trying to get him on the record agreeing with one political party’s stance on a current hot-button issue.
On the other hand, when the Q&A sessions are finished, I’m often left feeling as if the Chairman doesn’t have strong control over his cognitive biases. Wednesday’s “Yes, we can have it both ways” moment (around 11:30 am Eastern time) from Ben Bernanke when pressed on how he can say that the Fed’s low interest rate policy in the early 2000s didn’t help drive the housing bubble, but today’s low interest rate policy can be credited with driving the housing recovery is one such moment.
There are plenty of other moments from the two days of Q&A that would be enjoyable to discuss. The discussions around too-big-to-fail, Bernanke’s reaction to being called a “dove,” and the Chairman’s comment, “the best way to get interest rates up is to have low interest rates” would be on my list. But the one I would like to touch on in this article concerns the Fed’s “exit strategy” for unwinding its balance sheet. Learn more about the Fed’s balance sheet here.
On Tuesday, when Bernanke was asked about selling a big portion of the securities the Fed has purchased in recent years in order to wind down the Fed’s balance sheet, the Chairman responded, “We don’t anticipate having to do that.” He continued, “We could exit without ever selling, by letting it run off and we could tighten policy by raising [the] interest rates that we pay on reserves. That would be one strategy, for example.” In fact, I think the chances are quite good that the never selling approach will be the strategy that wins out. After all, should the Fed ever reach the point that it would consider selling securities, it will be at a point when the economy is in self-sustaining mode (if that day ever arrives). At that time, who is the Fed going to find that will want to buy from the Fed the hundreds of billions, if not trillions, of securities the Fed will want to slowly sell? The Fed beginning to wind down its balance sheet would be a form of monetary tightening. Unless the Fed forces certain banks to purchase the securities, I doubt it would find enough willing buyers of fixed income securities at the beginning of what the markets would likely interpret as a tightening cycle.
The same topic (exit strategy) came up on Wednesday, and Bernanke responded with the following:
“We haven’t done a new review of the exit strategy yet. I think we will have to do that sometime soon. Even if we don’t sell any securities, it doesn’t mean that our balance sheet is going to be large for many years, it just would be maybe an extra year, that’s all it would take to get down to a more normal size. So that’s one issue, is how long to hold those securities and whether to use that as a substitute, an alternative, to asset purchases.”
In response to Bernanke’s comment, the first question I have is what he defines as a “normal size” balance sheet? Exactly how many trillions of dollars worth of securities need to be wound down before the Fed can think about raising rates again? Also, I’d like to remind the Chairman that in recent rounds of QE, the Fed has become the market in the long end of the Treasury space. And the longer QE goes on, the more long-duration bonds the Fed will hold. The more it purchases and the bigger the exposure to longer duration bonds on its balance sheet, the longer we will all be waiting for the Fed to wind down the balance sheet by allowing the bonds to mature. With that in mind, I’d be curious to know what the Chairman was thinking when he said it would only be “maybe an extra year” to get the balance sheet to a normal size. It seems to me impossible for him to know that when the Fed is still in the midst of purchasing assets (and likely will be for some time to come).
When thinking through when the Fed might raise interest rates again, keep in mind that it will be a form of tightening just to stop asset purchases, and then another form of tightening to wind down the balance sheet. If the Fed’s strategy for unwinding its balance sheet becomes a wait-for-the-securities-to-mature strategy, then fixed income investors who are hoping for sustainably higher rates at any point over the next many years are likely to be disappointed. I suspect we could get the occasional bump higher in rates as the market gets ahead of itself expecting a rate-hike cycle (we’ve seen that a few times since 2008) and during normal seasonal rallies in yields, but I also suspect that those episodes of higher rates will be short-lived.
Investors will eventually realize that the Fed will not raise rates until after the balance sheet has been sufficiently “normalized” (however it defines “normal”) and that the wait for a normalized balance sheet will be a long one as we wait for the Fed’s ever-longer-in-duration securities to mature.
For quotes from the two days of Q&A and for a written version of Ben Bernanke’s Congressional testimony, see the links below:
Chairman Ben S. Bernanke’s “Semiannual Monetary Policy Report to the Congress”
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