Fed Openly Discusses “Permanently High Balance Sheet”; Lie Finally Admitted

Merits of Not Shrinking the Balloon

When the Fed first launched QE, they stated they had the “tools” necessary to shrink their ballooning balance sheet.

I quickly made the claim, no thinking person on the planet believed that lie. 

ZeroHedge made similar comments, as did others. So no one is a genius for predicting today’s non-news headline Fed Weighs Merits of Jumbo Portfolio in Post-Crisis Era. 

 Once the Federal Reserve lifts interest rates from near zero, likely this week, the focus will turn to the other legacy of the crisis-era policies: the Fed’s swollen balance sheet.

The prevailing view is that the U.S. central bank’s $4.5 trillion portfolio, vastly expanded by bond purchases aimed at stimulating the economy, will have to shrink once rates are on their way up, and the Fed will just need to decide how quickly.

Now, however, there is a new twist to the debate, with some policymakers and outside experts saying that there are reasons to keep the balance sheet big.

As recently as September 2014, the Fed pledged to eventually “hold no more securities than necessary,” in its “normalization” plan, a level widely interpreted as close to its pre-crisis $900 billion size. 

A “permanently higher balance sheet … is something that we haven’t studied that much but I think needs a lot more thought,” John Williams, president of the San Francisco Fed, said last month.

It could also give the Fed a permanent policy tool with which to target sectors of the economy and certain parts of the bond market.

For example, the Fed could buy and sell certain assets to stimulate or cool the mortgage market or to affect longer-term borrowing costs, says Benjamin Friedman, former chairman of Harvard University’s economics department.

Fed researchers have been studying how many and what type of bonds should be stay on the Fed’s books in a “post-normalization world” – an effort one source familiar with the work called a “once in a decade” research opportunity.

Ben Bernanke, who as Fed Chairman unleashed the bond-buying that pushed the balance sheet to its current size, also weighed into the debate downplaying any concerns about the Fed’s outsized portfolio.

“The Fed could leave the balance sheet where it is and that wouldn’t be a problem,” he told New York Economics Club last month, noting its size is “internationally normal” in relation to the economy’s output.

One result of the swollen portfolio is the $2.6 trillion in excess reserves that banks now park at the Fed, earning interest that will only rise as rates tick higher.

The idea that the Fed is paying extra billions to the very banks blamed for the crisis could re-ignite criticism from lawmakers already sour on the Fed’s aggressive stimulus.

A big balance sheet poses “huge optics problems,” says John Cochrane, a senior fellow at the Hoover Institution.

Still, there are obvious financial stability benefits to keeping the balance sheet large, he says.

One thing is clear: the Fed has not shut the door on keeping a bigger balance sheet for longer, or using it as a policy tool on top of its usual lever of setting short-term borrowing costs.