In a recent blog post, Ben Bernanke makes the case for delaying balance sheet contraction until after the fed funds rate has risen significantly further.
FWIW, I share Bernanke’s view that shrinking the balance sheet is not a pressing priority. However, I disagree with the argument he offers, for reasons I will elaborate in a follow-up post. In brief, I think he is misstating how QE “works”, again.
First, though, I need to pursue my own theme. I have argued that the standard interpretation of the taper tantrum is flat wrong and that the bond market back-up achieved during that period had nothing to do with portfolio balance but was all about signaling. Here, belatedly, Bernanke says pretty much the same thing. I just wish he had said “most”, rather than “much.” Getting closer. Emphasis added:
The Fed’s large-scale asset purchases were undertaken because, with interest rates nearly at zero, conventional interest-rate cuts wouldn’t suffice. However, as the FOMC recognized at the time, this relatively unfamiliar tool presented challenges, including the difficulty of estimating the effects of a given amount of asset purchases on near-term financial conditions. Predicting what market participants would infer about future policy from the Committee’s announcements about its asset-buying plans—the so-called signaling effect—was particularly challenging. When, as Fed chair, I indicated in testimony in 2013 that the FOMC was considering slowing asset purchases if economic conditions improved sufficiently, the markets responded with a “taper tantrum” that included sharp increases in volatility and a rise in longer-term rates. Much of this response came through the signaling channel, as some market participants inferred that slower asset purchases also implied a more-rapid increase in short-term interest rates. The taper tantrum calmed after FOMC members pushed back on that incorrect inference, emphasizing that short-term rates would remain low well after asset purchases were phased out.
And yet people interpret the taper tantrum as evidence that the portfolio balance approach was relevant. Well, when they threatened to taper, bond yields went up. So there is that. Yeah, but not really, though, eh? Hence, I will feature the heretical take on my front page again.
I will have more on this later.