Yellen: Shrinking balance sheet ‘longer-run goal’ but not active policy tool

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Federal Reserve chair Janet Yellen told members of Congress on Tuesday that while it was a “longer-run goal” to shrink the central bank’s balance sheet to a point where it will be “substantially smaller” in the future, she didn’t see that process as a “active” tool to manage monetary policy in place of interest-rate rises.

Ms Yellen, delivering her semi-annual testimony on monetary policy to the Senate, acknowledged that members of the Fed had enunciated “that its longer-run goal is to shrink” its $4.5tn balance sheet – which swelled in the wake of the financial crisis – “to levels consistent with efficient and effective implementation of monetary policy.”

As it does so, she said, “I’d anticipate a balance sheet that’s substantially smaller than at the current time”.

Nevertheless, Ms Yellen added the committee “would like to the maximum extent possible to rely on variations of the short-term overnight interest rate” to accomplish its policy goals.

She said it was her preference that they not rely on shrinking the balance sheet “as an active tool of monetary policy”, saying that the committee would in coming months be discussing issues about its reinvestment strategy “to provide some further guidance”.

Ms Yellen later added, in response to further questioning about the balance sheet:

“It is our desire to have an orderly process…Before we turn that process on, we want to make sure we have adequate ability, through our overnight interest-rate moves, to meet the needs of the economy, particularly if it were to weaken some…We want to make sure we have enough scope and that the economy is strong enough that that run-off wouldn’t create a problem for the economy.”

A series of Fed speakers have in recent weeks sent out trial balloons about the possibility of reducing the size of the Fed’s balance sheet in an effort to unwind its crisis-era interventions and reduce some of the pressure on policymakers from lawmakers who believe the Fed’s massive holdings could ignite inflationary pressure or pump up asset bubbles.

Analysts had been closely watching to see what, if anything, Ms Yellen might signal about the Fed’s next moves on its balance-sheet size during her testimony. In a note ahead of the hearing, Steven Englander, global head of currency strategy at Citigroup, wrote:

“The biggest nervousness in markets is probably about the risk that she discusses more openly the possibility of balance sheet reduction. This is unambiguously bad for the long end, but the question is whether it is good for the short end. If three hikes were priced in you might argue that balance sheet reduction could cut the number of policy rate moves from three to two. With two priced in and long rates sideways, it does not seem likely that she would give a nod to balance sheet reduction and one hike in 2017. Two hikes and balance sheet reduction would be hawkish as compared to current pricing.”

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