How Should the Federal Reserve Tighten?
The structure of the balance sheet and the range of administered interest rates presents a broad set of options for adjusting monetary policy. And the risk of negative net income may force their hand.
The policy stance that made sense in 2020 and 2021 is no longer appropriate. Most indicators now suggest that the U.S. economy has either fully recovered from the economic shock of the pandemic, is on track to fully recover in the next few months, or is already ahead of where it would have been in the absence of the pandemic.1 Thus the Federal Reserve is poised to begin “removing accommodation” in the next few weeks. Some officials may even want to go beyond “neutral” and actively restrict economic growth in the name of inflation control.2
What exactly does that mean?
The common assumptions are that the Fed will lift the interest rates it pays on its repo and deposit facilities in quarter-point increments to maintain its new corridor system3 and that it will shrink its bond portfolio by gradually reducing how much it reinvests maturing principal payments.
While that may be how things play out, it’s worth noting that the Fed has a wider range of tools at its disposal to achieve the desired change in financial conditions than it did in past cycles. Policymakers have unprecedented flexibility in how they choose to withdraw support—or slam the brakes—depending on their preferences and the economic outlook.
This newfound flexibility comes from the central bank’s expanded role as a financial intermediary that offers a range of services to a broad swathe of counterparties. In the past, the Fed mostly offered deposits (reserves) and short-term loans (the discount window) to banks. Now, however, the Fed both borrows and lends in the repo markets with securities dealers, money market funds, and others. It offers deposits to “designated financial market utilities,” and it is still financing pandemic-era emergency lending programs. The Fed can change the composition of its liabilities and its assets in new and interesting ways.
Moreover, Fed officials may decide that they will need to use “unconvential” tools to tighten policy in a way that minimizes the appearance of losing money. The cost of the Fed’s interest-bearing liabilities could surpass the yield on the Fed’s assets as soon as 2023 or 2024. A prolonged period of negative net interest income wouldn’t have any direct economic or financial consequences, but it might invite unwanted Congressional scrutiny and could limit the Federal Reserve System’s ability to pay its employees without appealing for appropriations.
Among the possibilities for America’s monetary policymakers:
Squeeze bank lending without raising interest rates (at least not very much)
Raise short-term market interest rates while maintaining positive net interest income (potentially with the help of the Treasury)
Increase bond risk premiums faster than they shrink the balance sheet
Whether Fed officials will choose to take advantage of any of these options is anyone’s guess. All of them come with tradeoffs, so Fed officials may decide they would prefer to “lose money” rather than deal with the costs of unorthodox approaches. And if aggressive monetary tightening is unwarranted, then any innovation would also be unnecessary. But investors should nevertheless be prepared for the central bank to recalibrate policy at least as “unconventionally” as they boosted the economy during the worst of the crisis.