St. Louis Fed's Bullard Weighs the Impact of Quantitative Tightening

New York – Federal Reserve Bank of St. Louis President James Bullard on Friday offered his views on the future of the Federal Reserve’s balance sheet at the 2019 U.S. Monetary Policy Forum hosted by the University of Chicago’s Booth School of Business.

In his presentation, “When Quantitative Tightening Is Not Quantitative Tightening,” Bullard made the argument for why the Fed’s balance sheet policy may be less important today than it was during the period when quantitative easing was most effective.

The Federal Open Market Committee (FOMC) has raised the policy rate and, since late 2017, simultaneously reduced the size of the Federal Reserve’s balance sheet, he pointed out. Many have argued that the balance sheet reduction—or quantitative tightening (QT) as it is sometimes called in global financial markets—could operate in the background with relatively small macroeconomic effects, Bullard said.

Others argue that balance sheet reduction should have equal and opposite effects relative to balance sheet expansion, or QE, he explained, and, accordingly, that there may be relatively large macroeconomic effects.

The Case for Small Effects from QT

Bullard argued that the case for relatively small macroeconomic effects of balance sheet reduction is more accurate. He suggests that “it is indeed possible to view quantitative easing as having an important influence on the macroeconomy and simultaneously view the macroeconomic effects of unwinding the balance sheet as relatively minor.”

“This may be one reason why the FOMC’s balance sheet reduction policy beginning in the fall of 2017 seemed to have only minor effects in financial markets,” Bullard said.

The balance sheet reduction has arguably been significant, he added, pointing out that the Fed has been able to reduce reserve balances by about 40 percent from the peak.

Baseline Neutrality

Bullard noted a 2010 paper¹ suggesting that in situations where financial markets are functioning properly, temporarily expanding the level of reserves beyond the satiation point for banks would have no direct effect on the economy.

This is one way to formulate a neutrality theorem for the size of the Fed’s balance sheet in ordinary times or when the policy rate is well above the zero lower bound, he explained.

“A baseline neutrality theory suggests temporarily increasing the Fed’s balance sheet size beyond the minimal level needed to implement monetary policy has no macroeconomic effect at all when the policy rate is well above the zero lower bound,” Bullard explained.

Signaling Effects

However, while the Fed’s policy rate was near zero, the Fed’s balance sheet policy nevertheless had an important macroeconomic impact through a signaling channel, he continued.

Bullard noted that actual effects of quantitative easing appear to be far from neutral,² and one theory as to why this may be so is that QE did not have direct effects but did send a credible signal about how long the FOMC intended to keep the policy rate near zero.

With the policy rate near zero, he explained, the FOMC may wish to signal convincingly that they will keep the policy rate near zero “for longer,” that is, beyond the time that an ordinary approach to monetary policy would call for rising rates. “QE may have been a good approach to accomplish this objective,” he said.

“Once the policy rate rose above the lower bound, balance sheet movements no longer provided a valuable signal about the future direction of monetary policy,” he added.

This means that baseline neutrality would again apply, Bullard said, “and the size of the balance sheet could be reduced without important macroeconomic consequences.” In other words, the balance sheet reduction could occur “in the background,” he noted.

Asymmetric Effects

In summary, the financial and macroeconomic impact of the FOMC’s balance sheet policy may well be asymmetric, Bullard noted.

“With the policy rate near zero, the effects of QE may have been substantial due to signaling effects,” he said. He pointed out that the FOMC normalized the policy rate to a considerable extent during 2017 and 2018. “Now, with the policy rate well above zero, any signaling effects from balance sheet changes have dissipated,” Bullard added.

This means quantitative tightening does not have equal and opposite effects from quantitative easing, he pointed out. “Indeed, one may view the effects of unwinding the balance sheet as relatively minor,” he said.

¹ See V. Cúrdia and M. Woodford, “Conventional and Unconventional Monetary Policy,” Federal Reserve Bank of St. Louis Review, July/August 2010, 229-64.

² See S. Bhattarai and C.J. Neely, “An Analysis of the Literature on International Unconventional Monetary Policy,” Working Paper No. 2016-021C, Federal Reserve Bank of St. Louis, October 2018.