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Trump Talked, the Fed Listened: Let’s Shrink the Balance Sheet, Bullard Says

by Wolf Richter, Wolf Street:

Even a Fed dove! This could get interesting.

The Dow is titillating the entire world by verging for days within a hair of 20,000 without actually getting there. Hitting the Big One would be another reflection of what Trump had called during the campaign an “artificial stock market” in a “very false economy,” created by the Fed that had kept rates low “for political reasons.” The crowds ate it up.

He pointed out that “the only thing that’s strong is the artificial stock market,” which was “only strong because it’s free money because the rates are so low.” But there’d be a hitch: “At some point the rates are going to have to change,” he said.

“They’re keeping the rates down so that everything else doesn’t go down,” he told reporters when they asked him about a rate hike in September.

And the Fed listened. Now the Fed has raised the fed funds rate, after flip-flopping vociferously an entire year, and is playing with the idea of three more rate hikes next year. Even Fed doves are suddenly getting antsy, after luxuriating in eight years of ZIRP and six years of QE.

On Friday, it was St. Louis Fed President James Bullard’s turn. In an interview, he told the Wall Street Journal that the Fed should consider shrinking its $4.5 trillion balance sheet in 2017; it “possibly might be a good time to play that card,” he said.

During its five years of QE, the Fed has acquired $2.46 trillion in Treasury notes and bonds and $1.75 trillion in mortgage backed securities (MBS). As these securities mature, the Fed buys similar securities as a replacement to keep the balance sheet from shrinking. Thus, the Fed continues to be a powerful buyer in the markets.

This certainty that the Fed is buying assets infuses confidence into the markets and inflates prices. It lures investors into chasing yield in ever riskier assets with ever lower returns, resulting in low cost of capital for Corporate America. It has created what Trump called the “false economy” and the “artificial stock market” where financial engineering has taken precedence over investment in productive activities that would actually move the real economy forward.

That was the idea from the beginning. It’s the foundation under today’s dizzying asset prices.

Bullard would start by allowing maturing securities to roll off the balance sheet without replacing them with new asset purchases, he said. That would shrink the balance sheet. And it would make financial conditions more restrictive.

Shedding assets accumulated on the Fed’s balance sheet is the ultimate form of tightening. It would pull liquidity out of the markets and force them to stand on their own wobbly feet.

And he’s a dove! He sees only one rate hike next year. Until recently, he saw only one rate hike, period – the one we just got – and no additional hikes over the next few next years. But he’s ogling the balance sheet.

If shrinking the balance sheet is too radical for now, the Fed could replace longer term securities as they mature with short-dated securities, he said. This would make unwinding the balance sheet easier, once the decision is made. These short-dated securities could just be allowed to mature without replacement. It could go pretty quickly.

“My preference would be to allow some runoff in the balance sheet,” he said. But before markets could spiral into a paroxysm, he added that he didn’t think efforts to shrink the balance sheet were “imminent.”

He has been a voting member of the Federal Open Market Committee, which makes the decisions on rates, QE, and balance sheet shrinkage. But next year, he’ll rotate into a non-voting slot. So he’s just setting some trial balloons adrift.

Read More @ WolfStreet.com

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