I copied that title from the Washington Post. It’s an important question and one that I keep seeing over and over again. I think the answer is rather simple and the Washington Post doesn’t provide an entirely accurate answer. The article states:
“Eventually, the Fed will likely need to shrink its balance sheet and/or raise interest rates to undo its easy money policies and prevent inflation from getting out of control. And when that day comes, the Treasury bonds and mortgage securities it owns will probably be worth less (when interest rates are higher, the old securities with low interest rates become less valuable).”
The Fed doesn’t really have to shrink its balance sheet to tighten policy. So it doesn’t have to shrink its balance sheet to raise rates. The reasoning here is simple. The Fed is currently paying interest on reserves. So the Fed Funds Rate that we all think about is rather irrelevant. That is, the IOR rate is now the de facto FFR. If the Fed were not paying interest on reserves the reserves would put downward pressure on overnight rates and the Fed wouldn’t be able to support the Fed Funds Rate. But the IOR solves that problem. In other words, it allows the Fed’s balance sheet to expand while also keeping control of rates.
The implications here are basic. If the Fed wants to tighten policy they don’t have to shrink their balance sheet (though I guess they could). Instead, they’ll just raise the rate on reserves. And that means there’s no urgency about shrinking the balance sheet. And that likely means the Fed can ease out of its current holdings over a very long time or it can simply let them mature on the balance sheet. Either way, I don’t see huge risks to the Fed losing money unless they mismanage the portfolio. They own government guaranteed paper and can afford to hold it to maturity. Losing money on that portfolio would take a truly brain dead trader….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.