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The Fed & the Central Banking Order of Operations
The abstract-style art of central banking
Despite the drastically different origin stories of the pandemic crisis and the Global Financial Crisis, the broad arc of the financial policy response was the same: Cut rates, engage in quantitative easing to the max, and roll out emergency liquidity facilities aimed directly at crucial credit markets. As fear of a deflationary crisis gave way to fear of an inflation crisis after the covid response, central banks went into reverse: Close the emergency facilities, stop buying bonds, begin to raise rates. However, with financial markets becoming increasingly unstable while inflation is still burning hot, Fed officials have finally—and shrewdly—begun communicating a willingness to be flexible with this established order of operations.
QT for Doves
On January 18, Dallas Fed President Lorie Logan said in a speech [my emphasis]:
Unlike with the fed funds rate, we are not adjusting asset runoff in response to the economic outlook. Rather, because our assets back our liabilities, like currency and bank reserves, the path of our assets will depend on the need for those liabilities. As our assets run off, our liabilities also fall. We can continue that process as long as we are providing enough currency and reserves for the payments, banking and financial systems to function smoothly.
To be sure, this passage does not provide a Fed reaction function for a market instability moment—as such a moment could also be characterized as a problem of too few reserves in the financial system.1 (More from Logan on that below.) It does, however, suggest that the need to pause or cut rates does not imply anything for the balance sheet. Part of this is an old story—we’ve made rate cuts great again. It’s been a while since the Fed had the 500 bps of policy rate space it typically needs for a recession; remember recessions without QE? It also suggests something new: not only would QE not be needed, but the Fed could continue QT into a downturn.
On January 20, Fed Governor Chris Waller offered a nice explanation for such a scenario. In response to a question about possible tension between balance sheet policy and rate policy, he said he’d be fine with cutting rates while continuing the balance sheet unwind. He said he views the act of unwinding the balance sheet as simply an exercise in credibility, that the announcement of the unwind did all the actual heavy lifting:
All those price effects [of QT] have already been priced in. You’re not really adding anything by actually doing it.
QE for Hawks
Broadly speaking, the Fed’s recent experience with inflation is itself an argument for upsetting the established order . . . of operations for central banks. By late 2021, it had become increasingly plain that the inflation problem was going to require the Fed to react. However, the Fed was still adding to its portfolio. The Fed started—and then accelerated—its tapering process to get the balance sheet flat by March 2022, only then lifting rates off zero.2
While he was then an ex-Fed official, former Fed Vice Chair for Supervision Randy Quarles gave that mea culpa last July. On David Beckworth’s Macro Musings podcast, Quarles said the Fed should have moved on the policy rate despite the fact that they’d not yet had the chance to steadily stop QE:
[Given] the relative power, if you will, of interest rate policy versus balance sheet policy, I think that in those circumstances, for a limited period of time, to have said, "Yes, tapering the balance sheet has to happen over an extended period of time to avoid disrupting markets, but we're going to begin raising interest rates even before that taper is complete because now is the time to move more aggressively in the response to inflation." … I think that would've been wise.
[…] I think that last fall would've been a time for the Fed to slip policy down onto the right glide path by beginning to raise interest rates even before the balance sheet taper was complete.
Then, on March 3, we got two speeches from FOMC members pointing towards the possibility of actively growing the balance sheet during monetary tightening. Both spoke at the Workshop on Market Dysfunction at the University of Chicago Booth School.
Fed Governor Michelle Bowman said, my emphasis:
The pandemic experience illustrated that liquidity strains can sometimes be so severe that targeted purchases of the affected assets may be the most effective tool to quickly support market functioning, as was the case in Treasury markets in the spring of 2020. In taking this step, a key issue for central banks to consider is how to clearly distinguish asset purchases from the central bank's monetary policy actions. This would be especially important during a period of monetary policy tightening, as we are currently experiencing.
President Logan was back, in something of an opus, with similar remarks:
The need to distinguish support for market functioning from monetary accommodation is most obvious when monetary policymakers are trying to tighten financial conditions to reduce inflation.
Previous notes on this site have explored the Fed’s tools and precedents in a situation where they had to continue hiking rate after something “breaks,” as well as a market stability version of “Operation Twist” in the Treasury market—where the Fed is buying and selling at the same time. The Fed’s communications seem to be increasingly opening to the possibility for such.
I’m not suggesting that any of this is explicit forward guidance that’s going to affect the next meeting’s outcome. Yet, these communications are notable, particularly given the increasingly choppy financial conditions we’re currently experiencing.
Moreover, until very recently, much ado was being made about how Fed officials were projecting a higher rate path than the market. While the market’s rate path has moved higher on recent data and Powell’s congressional testimony, we’re also due for a new set of projections from the FOMC this month. In the event the market begins working dovishly against the Fed again, continued communication that the Fed is not tethered to the classic order of operations could help remove some left-tail dovishness risk from rates markets.
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Reserves are a “right amount, right place” item. If they were always in the “right” place—i.e., where the financial system needed them—you can run the balance sheet a lot smaller. Running the system with a higher amount of reserves, however, helps insure against the situation where reserves dislocated.
St. Louis Fed President had pushed for tapering to originally be on the accelerated schedule “because I want to be in a position to react to possible upside risks to inflation next year”—suggesting that being “in a position to” raise rates required QE being done. Precisely the classic order of operations.