Fed’s Dudley: Lots of Ways To Shrink Balance Sheet

New York Federal Reserve Bank president William Dudley Saturday joined Federal Reserve vice chairman Donald Kohn in downplaying fears about the Fed’s bloated balance sheet.

Dudley, echoing earlier comments by Kohn, said he is “not worried at all” that the Fed’s expansionary credit policies will accelerate inflation. He said the Fed has the ability to “manage down” its balance sheet and has “plenty of options” for doing that.

Dudley — who succeeded current Treasury Secretary Timothy Geithner as New York Fed president in January and who is vice chairman of the Fed’s policymaking Federal Open Market Committee — said “some variability” in the size of the Fed’s balance sheet is needed.

Kohn and Dudley were appearing at a conference at Vanderbilt University in Nashville.

The Fed has not only slashed short-term interest rates to near zero, it has more than doubled the size of its balance sheet and in turn bank reserves and the monetary base through aggressive lending and securities purchases. This has given rise to concerns, not just from outside critics, but by some Fed officials. One is that Fed policies will drive up inflation as the economy improves.

Earlier, Kohn vowed the Fed will reverse its credit programs, reduce bank reserves, and raise interest rates “in a timely fashion” to contain inflation. But he said it is hard for the Fed to assess how much more credit it needs to provide in the current uncertain climate. So he said it must be “ready to adapt policy flexibly.” He said the Fed may need to reverse its credit easing to forestall inflation. Or it may need to do more if monetary and fiscal stimulus doesn’t succeed.

Kohn also addressed charges that the Fed is engaging in “credit allocation” and is jeopardizing its political independence by working so closely with the Treasury. He said the Fed is not trying to favor some borrowers at the expense of others, and he pledged that the Fed will guard its ability to make policy independent of political pressures.

Dudley made three points about the Fed’s balance sheet, which he noted has risen from around $900 billion prior to the failure of Lehman Brothers last September to $2.2 trillion.

First, he said the Fed’s goal is “not the expansion of the balance sheet per se,” but rather its objective is to providing liquidity to slow the deleveraging process, expanding the balance sheet capacity of the private sector, and improving  market function and easing financial market conditions.

Rather than aiming to increase reserves on the liability side of the central bank’s balance sheet, as the Bank of Japan did with its “quantitative easing,” Dudley said the Fed’s strategy has been to “act on the asset side of the balance sheet as the Fed lends funds against less liquid collateral and expands its asset holdings via purchases of agency debt, agency MBS, and Treasuries.”

Second, Dudley said that “the size of the balance sheet is not a good metric for measuring the impact of the Fed’s facilities or the amount of stimulus that the Fed is providing via those programs.”

For example, he said: “A Fed facility that eliminates rollover risk might not be used at all. There might be no balance sheet impact. Nevertheless, the facility could have an important impact on market function and financial market conditions.”

“It is not possible to mechanically map the size of the balance sheet back onto the impact on financial market conditions,” he said. “That is because the balance sheet size is being driven by a large number of different actions.”

Dudley’s third point was that he is “not worried at all that the Federal Reserve’s balance sheet expansion will generate an inflation problem.”

— Market News International

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