The Challenges Ahead for Fed Monetary Policy

来源: CHINA FOREX 2017 Issue 4 作者:Gao Zhanjun
T  he Federal Reserve has been on a path of monetary policy normalization since December 2015 when it raised interest rates for the first time after the 2008 financial crisis. Since then, there have been another four rate hikes, and the Fed finally began shrinking its balance sheet in October 2017. So far, the economy remains on a trajectory of slightly above-trend growth, stock markets have kept on rising steadily, and bond markets have not fluctuated dramatically.

Yet, the central bank is on relatively thin ice. Monetary policy is at a critical juncture and mistakes are easily made. The complexity of the problem lies in that, despite almost full employment, inflation remains low, leading to the unsolved Phillips curve puzzle, which addresses the relationship between prices and unemployment. Stock prices are high but wages have stagnated, highlighting the contradiction between inflation targets and the control of asset bubbles.

Especially under nearly full employment, tax cuts and investment in infrastructure will increase the pressure on monetary policy. As monetary policy normalizes, the economy may slow and even sink into recession. And if the economy slumps, monetary policy will likely lack the space and tools to deal with the challenge.

However, at this critical moment, President Trump has picked a new Fed chair -- Jerome Powell -- to replace the experienced and widely respected Janet Yellen when her term ends in February 2018. As those challenges draw nearer, what key uncertainties lie ahead?  The last Federal Open Market Committee (FOMC) meeting for 2017 in December offered a view of a strong labor market and strong economic growth. And it surprised no one by raising rates once again by one quarter percentage point.

How Will the Fed Shrink the Balance Sheet?
The FOMC policy meeting in September drew unprecedented attention. The meeting had two hot topics: one was whether to raise interest rates, and the other on how to shrink the balance sheet.

As markets had expected, the target range for the federal funds rate remained unchanged. But based on the optimistic assessment of the economy, inflation and employment situation, the Fed will continue to raise interest rates gradually in the future. At the December meeting, the federal funds rate was raised to a range of 1.25% to 1.5%. The "dot plot," which maps where the FOMC members see interest rates over the next few years, shows that the Fed still expects to raise rates three times in 2018.

Meanwhile, the timing for a balance sheet reduction is perfect, because bond yields are low, inflation is weaker than expected, the sustainable neutral real interest rate is far below historical levels and reserves are abundant. Despite these favorable conditions, the Fed has been warming up since June, and carefully designing the plan to avoid a sharp rise in effective interest rates as a result of a balance sheet reduction.

If the Fed wants to shrink its $4.5 trillion balance sheet to the pre-crisis level at its stated pace, it will take seven years to reduce that total by $3.7 trillion. Will the Fed go that far and will the Fed’s balance sheet reduction process continue uninterrupted for seven years?

In the process, for example, if the US economy slows down significantly, inflation remains below target, or even the unemployment rate starts to rise, the Fed may stop unwinding its positions. And if the impact on the market is substantial, it might even reconsider purchasing bonds again, according to Yellen.

Even if the Fed's balance sheet reduction process is uninterrupted, the Fed may not want to shrink its balance sheet to the pre-crisis level. Although the Fed's official statements have not mentioned this point, the influential New York Federal Reserve Bank President William C. Dudley, obviously has its own view. He has stated that the ideal size of the balance sheet after normalization should be within a range of $2.4 trillion to $3.5 trillion dollars. That means the Fed should cut its holdings by at most $1 to $2 trillion. Once they reach this level, the balance sheet reduction should stop. At this level, the Fed should even be ready to repurchase bonds if necessary.

If everything proceeds as Dudley expects, then the balance sheet will not be reduced to the pre-crisis level. It actually means that the purchase or sale of bonds by the Fed, which is thought to be an unconventional monetary policy tool, will become a conventional one in the central bank's tool box, alongside the policy rate. If so, the worries that the Fed might not be able to successfully complete such balance sheet reductions are unnecessary. The Fed would undoubtedly write a new chapter in the history of monetary policy by this method of regularization.

The biggest challenge for the Fed in shrinking the balance sheet is how to avoid a sharp rise in bond yields. If bond yields climb dramatically, this will not only disrupt financial markets but have an impact on the economic outlook. Moreover, another important point is that because the Fed holds a large number of bonds, if yields rise significantly, losses may be inevitable based on fair value. When monetary policy is able to directly affect monetary authorities, the primarily market-neutral central bank will find implementing monetary policy more than a little awkward, because the central bank needs income and the Fed also must contribute its profit to the US Department of the Treasury.

The Fed has started to scale back, but will other central banks follow? The Fed, the European Central Bank, the Bank of Japan and the Bank of England collectively hold balance sheets of $12.8 trillion, of which $9 trillion, or 88.27%, is in bonds. The answer is that they will act but not be forceful in the near future.

Another topic that is widely discussed is whether the People’s Bank of China (PBOC) will follow the Fed in reducing the balance sheet. They are actually two concepts since the PBOC does not proactively hold bonds, and the largest part of its assets are the 22 trillion yuan of foreign exchange. The second largest is the 8.6 trillion yuan in creditors' rights against commercial banks, much different from the Fed’s holdings, of which 95% are in bonds. In addition, the Fed's balance sheet has expanded dramatically since the financial crisis of 2008, but the expansion of the PBOC’s balance sheet has evolved over 15 years.

Naturally, the monetary policies of China and the United States are interconnected, but the influencing factors are constantly changing. At present, China's monetary policy operation should be considered more in the context of the domestic economic situation and financial deleveraging.

Three Challenges for the New Fed Chair
By most standards, the first rate hike made by the Bank of England in nearly a decade, or the announcement of the tax plan by the US Department of Treasury, would be a big event. However, Jerome Powell actually dominated the headlines, as he was nominated by the US president to be the next chairman of the Federal Reserve.

Then came the news that Dudley, the New York Federal Reserve president would step down ahead of time, presumably less than happy with the decision not to reappoint Yellen. Stanley Fischer, the former vice-chairman of the Fed, left the Fed in October, for a total of three key members stepping down. An era has already come to an end, the one with a strong team identity and consensus beyond party affiliation and characterized by the Fed’s traditional technocrats.

Powell was active during the race for the chairman of the Federal Reserve. On October 12, he attended the annual meeting of the Institute of International Finance in Washington, and delivered a speech on the prospects of emerging markets as the global economy normalizes. The logic of the speech was clear but the message was underwhelming. Powell seldom made eye contact with his audience and his presence was far from commanding.

In his speech, he was optimistic about the normalization of  monetary policy, arguing that the US economy was in a steady recovery, with a solid economic base for raising interest rates and shrinking the balance sheet. That is close to Yellen's view, broadly in line with the Fed's policy tone.

But on the issue of rate hikes, Powell appears to be a little more hawkish. According to the FOMC projection, by the end of 2020, the federal funds rate will reach 2.9%, but Powell suggested that even if rates went 50 basis points above that level, which would still be far below the pre-financial crisis level of 2008, the economy would be able to adjust, as long as the rate hikes are gradual and orderly. This kind of confidence in the economy's resilience could indicate an inclination to seek more interest rate hikes than his predecessor.

He also stressed that low volatility and high asset prices in global markets could also exacerbate market adjustments and create a snowball effect.

In addition to monetary policy, the Fed has the responsibility of financial regulation. Although Powell may not agree with all of Trump's views on deregulation, his tone is clearly weaker than Yellen’s. This may be another reason why he was nominated by Trump.

It is not easy to sit at the head of the world's most important central bank. In my view, Powell will face a number of challenges when he takes office.

Challenge one: how to lead the Fed without a deep professional background? Powell is not only without a doctorate in economics, but he has not studied economics at all, let alone propose some profound economic theories. Despite years of experience in financial institutions and as a former under secretary of the treasury, he will still not find it easy to take the lead.

Challenge two: monetary policy is at its most critical juncture. The complexity of the problem lies in that, despite low unemployment, inflation remains low. Stock prices are high but wages are low, highlighting the contradiction between inflation targets and the control of asset bubbles. Second, under full employment, as monetary policy normalizes, the economy may slow down and even sink into recession in the near future, which puts a higher requirement on accurate judgment and a strong sense of the policy rhythm. Third, if the economy slumps, monetary policy will likely lack space and tools to respond adequately. Does Powell have the same creativity and willpower as former Fed chair Ben Bernanke?

Challenge three: will the Fed maintain its flexibility and independence in the face of increasing external disturbances? Among the disturbances, a real problem is that under full employment, tax cuts and investment in infrastructure, there will be increased pressure on monetary policy. However, Powell does not seem to be fully aware of the danger; he said not long ago that the biggest challenge for the economy is not growing fast enough.

How will Powell's policies operate in the face of these three challenges? Will there be a misstep? In addition, Powell attaches great importance to China and pays close attention to China’s leverage issue. He also thinks that the influence of exchange rate and global interest rates on Chinese enterprises is relatively limited. So how will his policies affect China?

On October 25, I attended a dinner meeting at the National Bureau of Economic Research in Boston, where there was a lot of disagreement about Powell's policy inclinations. Everything seems to be a test of time.

The final FOMC policy meeting of 2017 was the last for Janet Yellen as chair and governor. What signs of Yellen's legacy will we see in the minutes of the meeting?

According to the minutes from the FOMC’s Oct. 31-Nov. 1 gathering  this year, many participants thought that another increase in the target range for the federal funds rate was likely to be warranted in the near term if new data left the medium-term outlook broadly unchanged.

Fed officials remain confident in the labor market and above-trend economic growth. Household spending has been expanding at a moderate pace and the growth in business fixed investment has picked up in recent quarters. And most likely, the economy has solid momentum going into 2018, though it might be hard to get growth much above 3% on a sustainable basis.

Though inflation for items other than food and energy remains soft, several Fed officials are looking for stronger signs that price gains will quicken; a few even want to see inflation on an upward path before lifting rates again.

At his confirmation hearing in Washington before the Senate Banking Committee on November 28, Powell told lawmakers the case for another rate hike is strengthening, as the labor market improves without spurring an overheating of the US economy.

Before the December FOMC meeting, futures markets had been pricing in about a 90% probability of a rate hike. That was just as the  US tax act was about to be passed and headed for signing into law.

How about next year? The Fed will continue with its gradual tightening. In October, the Fed initiated the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans, and will continue to shrink the balance sheet as planned. According to my calculations, the Fed will reduce the balance sheet by about $30 billion in 2017, $420 billion in 2018, and another $600 billion in 2019.

Fed officials also have been projecting three rate increases in 2018, and of course, the actual path of the fed funds rate will depend on the realized and expected economic conditions as indicated by newly available data. The assessment of economic conditions will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

As Bernanke’s successor at the helm of the Fed, Yellen started raising interest rates and reducing the Fed balance sheet. During her term, economic activity has been rising at a solid clip, the labor market has continued to strengthen and unemployment rate has continued to decline. She has excelled at communicating with the markets. Yellen will surely end up with a pretty strong legacy.

Powell is very likely to show continuity with Yellen. It appears that he has a monetary policy philosophy which is pretty much consistent with Yellen’s Fed party line. In five years as a Fed governor, Powell has publicly supported the policies of chairs Ben Bernanke and Janet Yellen. He’ll provide support for the Fed’s normalization policy.

But going forward, will Powell take a fresh approach after he takes over as Fed chair? It would be natural if Powell characterized things differently, at least to some extent. Nevertheless, whether his possible fresh approach will surprise markets or not, it’s still hard to say at this point. But obviously, this possibility shouldn’t be completely ignored.

The author is a visiting scholar at Harvard University, and a former managing director at CITIC Securities