MNI INTERVIEW: 'Purifying' Fed's Balance Sheet Could Backfire

Offloading the Federal Reserve’s mortgage bonds or long-dated Treasuries via an asset swap with Treasury could trigger a spike in rates and, if done haphazardly, destabilize markets so severely as to require emergency intervention, former Fed Board of Governors research director David Wilcox told MNI.   

Such a swap has been discussed by economists as an aggressive approach to shrinking the Fed's USD6.5 trillion balance sheet -- a priority of Fed chair nominee Kevin Warsh -- and would create a Fed portfolio made up of only Treasuries with a maturity structure that would be either neutral or exclusively short term.   

"The advantage would be you'd get a 'pristine' balance sheet for the central bank and you'd get there immediately," Wilcox, senior fellow at the Peterson Institute for International Economics and director of U.S. economic research at Bloomberg Economics, said in an interview, adding few on the FOMC have been balance sheet "purists" and the committee has tolerated a non-pristine balance sheet for nearly two decades.  

"The minus is: If you did it in a not-well-thought-through way, you might end up with higher borrowing rates that matter for businesses and households. And you'd want to be very careful to build in break-the-glass type provisions in case of emergency." 

MBS SWAP

The Fed is keen to unwind its USD2.3 trillion holdings of mortgage-backed securities and is currently reinvesting maturing MBS in Treasury bills. The FOMC has discussed selling MBS outright but fears ratcheting mortgage rates higher.

Whether the central bank could acquire Treasury securities outside of the secondary market, as the law stipulates, and through an asset swap is legally unclear, Wilcox said. 

Still, some FOMC members would cheer giving over control of their MBS portfolio, as it would better align with the principle that the central bank not engage in credit allocation.    

"I've never really believed that there was anything morally superior about the Fed only holding short-term Treasury securities or abstaining from holding any mortgage-backed securities," Wilcox said. But a minority of central bankers strongly view Fed purchases of MBS as "favoring housing finance at the expense of potentially other legitimate valid uses of credit capacity."  

MARKET IMPACT

The impact on longer rates and broader financial conditions must be thoroughly analyzed if the Fed were to offload its MBS and long-dated Treasuries, Wilcox said. 

"Somebody would have to think through very carefully how that would be accomplished without bringing the market rates on those types of securities up," he said. "We can be reasonably confident President Trump cares little about the niceties of the composition of the Federal Reserve's balance sheet. What he does care very much about is the borrowing rates confronted by households and businesses." 

The Fed turned to QE only after lowering interest rates to zero, hoping to drive yields on MBS and longer-term Treasuries down by altering the composition of debt held by the public. It also hoped the behavior of the Treasury would not be affected by the Fed's actions, Wilcox said. By the same logic, a shift toward a shorter-duration portfolio will depend on how Treasury adjusts issuance in response. 

A smaller Fed balance sheet would result in higher long-term rates if the funds rate is already as low as it can go, making it impossible to cut rates further to offset those pressures, Wilcox said. 

"It would be a very unfortunate outcome if for the sake of some theoretical purity we gave up any recourse, any ability to purchase longer-term securities even in the event of a crisis," he said. (See: MNI INTERVIEW: Hawkish Accord Could Remove QE From Fed Toolkit)