MNI INTERVIEW: Hawkish Accord Could Remove QE From Fed Toolkit

A hawkish revamp of the 1951 Treasury-Fed accord under incoming chair Kevin Warsh could see QE removed from the FOMC's toolkit, robbing policymakers of a key support for the economy during crises, Johns Hopkins University economist Jonathan Wright, a former staffer at the Federal Reserve, told MNI.

Warsh has not detailed what might be in a new agreement but has called for the relationship to be redefined, with the Fed chair and Treasury secretary stating clearly their objective for the size of the Fed’s balance sheet. Speculation has ranged from a dovish pivot toward yield caps at the long end and fiscal dominance to the opposite -- a return to a significantly small balance sheet.  

"There is a hawkish version of it, which would be keeping the 1951 framework that the Fed does not have to buy long-term bonds or have to buy any Treasuries, but either capping the size of the Fed’s balance sheet, saying the Fed would only purchase Treasuries in very severe financial turbulence situations, or shifting the maturity composition of the Fed’s portfolio towards being something much more short-term," Wright said in an interview.  

"What would be consequential is saying that, going forward, the Fed could either only buy bills or have to work with a much smaller balance sheet, which has its advantages, but also disadvantages in that they don’t have any ability to stabilize the economy at the zero lower bound." (See MNI: Warsh Wants Fed Out Of U.S. Treasury's Business )

WITHOUT CONVICTION

The market reaction to such a move could be limited in the short run, but the economy would likely be in worse shape should another recession or crisis pull rates back to zero with the Fed powerless to do more. 

"We have spent about half the time this century at the zero lower bound. And at the zero lower bound, the only thing that the Fed has left in its toolkit is to buy Treasuries and mortgage-backed securities," Wright said. "I don’t think we'd be happy at all if the Fed had just sat on the sidelines and said, we’re stuck at the zero lower bound, there’s nothing more we can do."

Still, an exception would likely be made for Fed to undertake large purchases to alleviate severe market dysfunction, such as that of March 2020, and officials may waver in the face of a real crisis, Wright said. 

"What the definition of financial crisis is is always a bit difficult. And in severe enough circumstances, you could always imagine emergency legislation getting passed," he said. "I tend to think that any restrictions on the Fed’s ability to do QE under crisis situations are not likely to be very sticky."

ASSET SWAP

Reducing the balance sheet drastically would require restarting QT, changes to monetary policy implementation and the regulatory framework, and will take several years, Wright said. (See: MNI POLICY: Long Road To Scarcer Reserves For Warsh)

A swap of the Fed's longer-dated Treasuries or mortgage bonds for Treasury bills would speed things up dramatically, but such a maneuver would have few real implications, he said. 

"Given that at the end of the day, the Fed’s profits are all remitted to Treasury, that ends up being a wash. So, that doesn’t seem to me to be that consequential," he said. 

"If we’re talking about implications for fiscal dominance, the key question is: what can the Fed buy going forward?"