Panel on Shrinking the Federal Reserve Balance Sheet

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• Panel on Shrinking the Federal Reserve Balance Sheet
• Arvind Krishnamurthy, Sydney C. Ludvigson, and Jonathan H. Wright

• Lessons for Policy from Research
• Arvind Krishnamurthy

ABSTRACT

I review lessons from the research on central bank actions over the last decade and draw out implications for expanding the Federal Reserve balance sheet (quantitative easing) and shrinking the balance sheet (quantitative tightening). As I outline, there is already enough evidence in the research to indicate the manner in which the Federal Reserve could update its policy normalization principles and plans.

Former Federal Reserve chairman Ben Bernanke famously quipped, in a 2014 discussion at the Brookings Institution, that "the problem with QE is that it works in practice, but it doesn't work in theory." Academic and policy research on quantitative easing (QE) has come quite far over the last decade, and we are less in the dark about the workings of QE. In this paper, I review the lessons from this research and then draw out implications for expanding the Federal Reserve balance sheet (QE) and shrinking the balance sheet (quantitative tightening, or QT).

There are three principal lessons from the research: (1) QE works differently than conventional monetary policy in that the impacts are highest in the asset market targeted. (2) QE impacts are highest during periods of financial distress, market segmentation, and illiquidity. While this statement is likely also true of conventional policy, the effects are much more dramatic with QE. (3) QE alters the quantity of central bank reserves, and the post-2008 regulatory and economic regime implies substantially higher necessary reserve balances. I review each of these points and then turn to their implications for the formulation of rules governing QE/QT. The Fed [End Page 233]

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View full resolution Figure 1.

Yield Changes by Maturity from UK QE for UK Gilts and Gilt-OIS Spreads

Source: Joyce and others (2011); copyright Bank of England and the Association of the International Journal of Central Banking; adapted with permission.

currently uses QE in two ways: to provide liquidity to markets during financial illiquidity episodes ("crisis QE") and to lower financing costs for borrowers at a time when the zero lower bound binds ("easing QE"). I argue that rules for these two types of policies should differ, but that the Fed has blurred the lines between them which has led to policy errors.

I. Lessons from Research

I.A. QE Works through Narrow Channels

Joyce and others (2011) present data from an event study around two significant QE news dates in 2009 by the Bank of England. On February 11, 2009, the Inflation Report and the subsequent press conference gave a strong indication that the bank would do QE. Markets interpreted this to mean that the bank would purchase bonds out to around fifteen-year maturity. On March 5, 2009, the bank announced that purchases would be in the five- to twenty-five-year range. Figure 1, replicating figure 4 in Joyce and others (2011), shows the changes in gilt yields around the event dates and the changes in the spread between gilt and overnight index swap (OIS) yields around these dates. Panel A shows the market reaction to the [End Page 234] February announcements: yields fall across the board. The pattern is similar to a conventional policy response in that there are larger effects on short-term bonds than longer-term bonds. In the curve showing the yield-OIS spread change, we see unique QE effects. If the policy transmission is akin to conventional monetary policy, there should be no change in these spreads as we would expect that both gilt yields and OIS yields will move in lockstep so that their spread would not change. Panel B shows the market reaction to the March announcement, and here we can really see the unique QE effects. First note that the effect on gilt yields is concentrated in the five- to twenty-five-year range, which the bank indicated as the target of QE purchases, with yields in the fifteen- to twenty-five-year range falling dramatically on the news that these maturities would also be purchased. Second, note that the yield-OIS spread change reflects the...