MNI INTERVIEW: Fed Assets Hard To Shrink Due To Deficit-Hoenig

The Federal Reserve will have a difficult time shrinking its balance sheet despite the stated predilection for doing so of Chair nominee Kevin Warsh, as gaping U.S. budget deficits require ongoing central bank largesse, former Kansas City Fed President Thomas Hoenig told MNI.

“I don't know that you can shrink the balance sheet without a major kind of Volcker event, and I think that would not be acceptable to this administration or this Congress,” said Hoenig in an interview, adding that this would involve a spike in bond yields, sharp drops in asset values and ultimately a recession.

Hoenig said he welcomes Warsh’s idea of a Treasury-Fed Accord that would reinforce the central bank’s monetary independence but said President Donald Trump’s pick needs to explain how he envisions such a plan.  (See MNI: Warsh Wants Fed Out Of Treasury's Business)

TREASURY-FED ACCORD

“I don’t know what Kevin means and I think it’s important that he explains what he means as soon as he can by a new accord,” he said.  

Hoenig noted that the Fed was quick to return to large-scale asset buys, this time of Treasury bills, almost immediately after ending its QT program. This is a sign that fiscal dominance has taken hold, said Hoenig, who overlapped on the FOMC with Warsh and was similarly critical of the QE2 program launched in late 2010.

“The debt is growing, and someone has to buy it otherwise interest rates go up,” he said. 

For Hoenig, a new Treasury Fed Accord would actually need buy-in not just from the White House and Treasury but also Congress, with a specific commitment to lower the debt. 

"We need an agreement where the Fed says we will slowly reduce our quantitative easing and our purchase of government securities. We won't shock you, but we will, we must decrease it. And Congress has to agree, yes, we're going to slow our spending." 

POLICY ACCOMMODATIVE

Hoenig said monetary policy is not neutral or mildly restrictive as the FOMC is currently arguing but has actually already veered into stimulative territory. 

“If you look at where real interest rates are today – think of inflation as close to 3%, the funds rate, or the policy range, is a little more than three and a half. So real interest rates are less than 1% – that's not a mildly restrictive policy. That's an accommodative policy right there in real terms,” he said. 

“I also think that, given the tax credits that have been put in, the increasing demand, the spending going on, the equilibrium rate is higher than 1%.”

That creates the risk of a fresh bout of inflation despite official reassurances that the current above-target levels are simply due to transitory tariff effects, said Hoenig.

“There's a real risk of inflation not coming down. Therefore putting policy on hold is the sensible thing to do.”

He believes that’s just what Powell will do until the end of his term in May. “I think Powell will be able to hold it constant through his term, unless unemployment shoots up,” he said, adding that for now he sees the job market as “probably close to equilibrium. (See MNI INTERVIEW: Fed In Watch Mode Through 1H, Lockhart Says)

INDEPENDENCE TEST

Starting in June, it remains to be seen what course of action his successor will take, said Hoenig, now a distinguished senior fellow at the Mercatus Center. 

Warsh is a strong pick to lead the central bank given his experience and knowledge base, but he will face tremendous challenges including ongoing pressure for lower rates from the administration, he said. “He has the experience and he has the wherewithal to do it. The test is yet to be administered.”