The Fed Must Avoid the 'Credibility Trap'

Yellen should focus on what’s really important: the balance sheet.

The Federal Reserve should admit its balance sheet is not going to be reduced for the foreseeable future. Even the guidance of doing so after “normalization is well underway” is an irresponsible course of action.

With its policies growing more reactionary, disjointed and incoherent, the focus on the Federal Reserve’s every move and the incessant speculation over when the next increase (or decrease) in the Federal funds rate will occur grows tiresome. The direction and conduct of monetary policy is increasingly volatile and damages the Federal Reserve’s credibility. It distracts from the potentially far more important, interacting issues surrounding Federal Reserve policy—the balance sheet and the terminal rate.

The Federal Reserve is currently reinvesting its $4.4 trillion balance sheet, stating time and again that it will not begin to unwind it until after the normalization process is “well underway”. Interestingly, the normalization process is well underway—tapering the third round of quantitative easing which removed a significant amount of accommodation, around 3 percent according to Federal Reserve researchers Wu and Xia. So by some metrics, beginning to allow the balance sheet to unwind is a logical step.

But just because the tapering of quantitative easing tightened financial conditions, does not mean the term “normalization” applies. Maybe it should, but the Federal Reserve does not seem to consider it part of monetary policy. The traditional tool—the Federal Reserve funds rate—has only been increased once. It hardly feels as though the process of normalization has commenced. The seesaw of expectations surrounding the path of monetary policy has placed the Federal Reserve in a credibility trap of its own making. Federal Reserve officials jawboning about their views on how monetary policy was set to unfold caused problems, and will again.

At the beginning of this year, the Federal Reserve was prepared to slowly raise rates throughout the year. But a weak start forced the Federal Reserve to back away from its previous path. From the beginning of January to early February, market expectations for an increase at its June meeting fell from about 45 percent to less than 5 percent. In January, there was more than a 50 percent chance the Federal Reserve was going to raise in March, and a 33 percent chance of two hikes by September. The credibility trap was now set.

But the economic data that followed was not supportive of Federal Reserve plans. Using their new found tool of forward guidance—the practice of talking markets through plans for the future—Federal Reserve officials collectively retreated from rate hikes. The most prominent voice was Chair Janet Yellen, and markets quickly reacted to her dovishness. Given the prevailing data at the time, this was the appropriate move, and ensured, the primacy of data dependence continued its reign.

This transition was initially well executed. The trouble emerged when the data improved. Sensing the need to reflate expectations for higher interest rates, Yellen and company abruptly reversed course with their rhetoric. And they did so straight into a highly visible—and horrible—jobs report. The rhetoric halted quickly.

Continuously flip-flopping has consequences; not the least of which is a deterioration in confidence that the Federal Reserve is capable of guiding markets. It also makes it exceedingly difficult to estimate the future path of rates with any confidence. Since the Federal Reserve cannot credibly guide markets toward a probable outcome of monetary policy when only the Federal Reserve funds rate is involved, can it reliably undertake the task of reducing the balance sheet?

In many ways, the Federal Reserve’s balance sheet is tied to expectations of where the Federal Reserve funds rate will eventually land. Even before the process of normalization has truly begun, the terminal rate is steadily declining. From the December meeting to June, the long-term rate estimate declined to 3 percent from 3.5 percent. When the Federal Reserve began releasing the Summary of Economic Projections—the “dots”, the long-term rate was 4.25 percent. Today, some independent estimates for the terminal rate sit as low as 2 percent.

In June of 2015, the Federal Reserve’s dot plot suggested the terminal rate was 3.75 percent and the Federal Reserve funds rate was between 0 and 0.25 percent. In the year since, the Federal Reserve funds rate has only been raised once, but the terminal rate has declined by 0.75 percent. While the Federal Reserve may have only raised rates by 0.25 percent, it has also slowly begun to admit that rates are incapable of increasing to the level assumed a couple of years ago. Without doing much at all, the Federal Reserve has undertaken a tremendous amount of normalization.

How the declining terminal rate will affect the Federal Reserve’s decision—or indecision—surrounding its balance sheet is anyone’s guess. And, although it is improbable the Federal Reserve will get around to reducing the balance sheet during the current tightening cycle for myriad reasons, the steady decline in the terminal rate begs the question: What is the necessary condition to begin shrinking the balance sheet? Or, more appropriately, how much longer will the Federal Reserve wait before admitting it is not going happen?