In their editorial on the Federal Reserve’s balance sheet this morning the editors of the Wall Street Journal ask what must now be the $100 trillion question (adjusted for inflation): what happens when the Fed “unwinds” its balance sheet, reverses its policy of the last nine years, and selling long duration Treasuries and mortgage securities?
This was supposed to lift asset prices and spur faster economic growth. The faster growth never arrived—despite Fed predictions for years that 3% annual GDP growth was right around the corner—in what has been the slowest modern expansion on record. But prices have risen in stocks, real estate, emerging-market plays and other assets.
If the Fed calls that a success on Mr. Bernanke’s terms, then shouldn’t the reverse happen as the Fed unwinds? That is, as the Fed unloads long-duration bonds, will investors sell some of those riskier assets to buy the Treasurys and mortgage debt the Fed won’t be buying? Will we see naked bodies if the tide recedes in some asset classes?
If we knew the answer, we’d be rich, but there’s certainly a chance for more financial volatility as investors react. This concern may explain the Fed’s slow unwinding, especially as it now pays such close attention to the stock market. The Fed seems to fear the effect of any stock correction on the “wealth effect,†even if corrections are useful in heading off investor manias that can become bubbles. (See the dot-com Nasdaq, year 2000.)
The effect on the real economy may be more sanguine, and in that sense the Fed’s timing is fortuitous. The world’s major economies are all growing at once for a change, and bank balance sheets in the U.S. are strong. The Trump Administration and Congress are moving toward what we hope is a pro-growth tax reform. The dollar has weakened considerably so there is little fear that monetary tightening will lead to an overvalued greenback. Inflation is contained, though it bears watching.
It might have no perceptible effects. It might cause a panick-stricken sell-off in the stock market. It might result in growth in the real economy. It might have some other unforeseen effect. Isn’t it fun being the mold in the world’s largest Petri dish?
My gut tells me it’s the first. I think the financial economy has become almost completely dissociated from the real economy. They’ve decided to divorce and go their own separate ways. I have a great instinct for numbers but my instinct for finance is much less.
Whatever happens each of the financial economy and the real one is bound to have its ups and downs, we’re sort of overdue for downs, and each is likely to blame the other which, if the past is any gauge, will result in the financial economy putting its hand out.
