Disruptive risks seen in bid to normalise Fed’s balance sheet
THIS week’s policy meeting of the US Federal Reserve’s Federal Open Market Committee ended up with another interest rate increase as expected by the markets. Fed chairwoman Janet Yellen also indicated clearly that the committee expected to begin implementing a balance sheet normalisation programme by the end of this year.
Global financial markets in the lead-up to the policy meeting had been more preoccupied by the Fed’s schedule of normalising its balance sheet than on the prospect of another rise.
The supporting reasons for another rate hike are obvious: the US economy is very close to full employment, wage rates have gradually moved up and inflation has slowly moved towards the target of 2 per cent annually, despite a halt in March due to a weak consumer spending.
The arguments for shrinking the Federal Reserve’s balance sheet, on the other hand, appear to be more controversial, both in terms of its timing and size. In order to understand fully the main points of these arguments, one needs to go back to the root of the problem that led to the current huge balance sheet.
In order to promote economic recovery after the global financial crisis in 2008, the Federal Reserve had started to implement a quantitative easing policy by purchasing large quantities of Treasury securities and US government-backed mortgage-related securities until 2014. As the result, the Fed’s balance sheet has expanded from US$900 billion to about $4.5 trillion.
The Fed’s current “quantitative tightening” policies would involve both a series of rate hikes and a shrinking balance sheet. The main questions of concerns for the opponents of this balance sheet normalisation are the appropriate operation timing and the optimal size of the balance sheet. Opponents are concerned about the risks of market disruptions as a result of unexpected large responses from the financial markets that may lead to sharp increases in volatility and a sharp rise in long-term rates, which may also lead to a rapid fall in asset prices.
Finally, it is crucial for the central banks of advanced and emerging economies to carefully monitor and prepare for the likelihood of shocks that might hit financial markets in response to this latest signal and the progress towards the Fed’s balance sheet normalisation plan.
Professor ARAYAH PREECHAMETTA is a lecturer at the faculty of economics, Thammasat University.
