KC Fed’s George: Taper criteria met, size of balance sheet needs to be discussed

September 24, 2021

By Howard Schneider

WASHINGTON (Reuters) -The U.S. job market has already met the Federal Reserve’s benchmark test to reduce it monthly bond purchases, Kansas City Fed President Esther George said, and the central bank should now turn to discussion of how its massive bondholdings may complicate its eventual decision about when to raise interest rates.

“The criteria for substantial further progress has been met…The rationale for continuing to add to our asset holdings each month has waned,” George said in remarks to the American Enterprise Institute.

While the ongoing pandemic remains a risk, with labor and goods markets still facing supply constraints and bottlenecks, she felt that those problems would ease over time and more normal patterns of consumption, work and hiring reemerge.

The challenge now for the Fed, she said, is to determine how its balance sheet, pushing $8.5 trillion in securities holdings, will complicate a coming discussion on interest rates.

Those asset holdings will remain in place even after monthly purchases fall to zero and “are depressing long-term interest rates most relevant for households and businesses…This accommodation will persist even when tapering is complete,” she said.

The Fed’s criteria for raising its short-term policy rate is that inflation is durably at the central bank’s 2% target and that maximum employment has been reached – benchmarks already hard to judge because of the pandemic.

George’s comments flag a next-stage policy debate that may pose a distinct set of tradeoffs for the Fed to consider.

In the years after the 2007 to 2009 financial crisis, there was a year between the end of the Fed’s bond “taper” and the first increase of its policy interest rate, and two years after that before the Fed stopped reinvesting the proceeds of its maturing bonds and allowed the balance sheet to shrink.

The process may happen faster this time. The bond taper is not expected to finish until the middle of next year, yet half of the Fed’s 18 policymakers feel interest rates will need to rise by the end of 2022. If inflation persists, it may leave the Fed promoting demand with low long-term rates but feeling the need to curb it with short-term rate hikes.

“Where along the yield curve would we prefer the most policy space?” George said, conjecturing the Fed might want to keep longer-term rates low by keeping its balance sheet large, but counter that stimulus with a higher short-term policy rate.That, however, might raise the risk of an inverted yield curve, an argument for shrinking the balance sheet “or at least shifting toward one with shorter-maturity assets, with a lower neutral policy rate.”

“As the economy recovers from this pandemic shock, its path is likely to confound our assumptions about what a return to normal might look like,” George said. “The same is true for the monetary policy normalization process. Both point to a long and difficult process ahead.”

(Reporting by Howard Schneider; Editing by Chizu Nomiyama and Andrea Ricci)

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