Bond investors may have another reason to worry after Donald Trump’s election last week: Some of his allies are not fans of the Federal Reserve’s big balance sheet of bonds and want the central bank to shrink it.
They argue that the Fed’s debt portfolio has damaged the economy by channeling credit to corporations and the federal government instead of to new, more dynamic small businesses. The central bank’s policies also have hurt savers and retirees, they say.
The Fed’s bond purchases “have been very harmful,” David Malpass, a senior economic adviser on the Trump transition team, said in an e-mail. It “needs to communicate a plan for downsizing its balance sheet.”
House Financial Services Committee Chairman Jeb Hensarling, who worked closely with Vice President-elect Mike Pence when the latter was a lawmaker, has also called on the central bank to reduce its $4.5 trillion balance sheet.
“It is way past time for the Fed to commit to a credible, verifiable monetary policy rule, to systematically shrink its balance sheet and get out of the business of picking winners and losers in the credit markets,” the Texas Republican said at a June 22 hearing on the central bank’s policies.
Bond prices have nosedived since Trump was elected president on Nov. 8 as investors concluded that his proposals for lower taxes and higher military and infrastructure spending would lead to faster economic growth and increased inflation.
A move to reduce the Fed’s bond holdings could put further downward pressure on prices by adding to the supply investors would have to absorb. Fed Chair Janet Yellen may get a chance to address the issue Thursday in testimony to the Joint Economic Committee of Congress.
“The Fed’s policies have contributed to the weakness in middle-class income by helping bond issuers, primarily the government and large corporations, at the expense of small businesses and savers,” said Malpass, who is president of Encima Global in New York.
The “pro-growth solution” would be to encourage bank lending, taper the Fed’s bond holdings and hold down the interest rate it pays commercial banks for their excess reserves, he said.
In a Nov. 11 interview on Bloomberg Radio, Trump adviser Judy Shelton echoed Malpass’s concerns.
Shelton, who is co-director of the Sound Money Project at the Atlas Network in Washington, suggested that the Fed’s policies were channeling low-cost funding to “wealthy investors, and corporate borrowers and even big government” instead of to “the average person with just a bank savings account.”
Trump was critical of the Fed during the presidential campaign, at one point charging that its low interest rates were fomenting a “big, fat, ugly bubble” in the stock market. He also complained that the central bank had been more political than his Democratic opponent, Hillary Clinton — a charge that Fed Chair Janet Yellen repeatedly denied.
With two slots vacant on the Fed’s seven-seat board, Trump will have an opportunity to nominate monetary policy makers more to his liking when he takes over as president in January. He’ll also have a chance to pick a new chairman and vice chairman in 2018, when Yellen’s term and that of her deputy, Stanley Fischer, expire.
The Federal Open Market Committee is widely expected to lift interest rates when it meets next month after raising them at the end of last year for the first time since 2006.
Policy makers have said they anticipate maintaining the size of the balance sheet “until normalization of the level of the federal funds rate is well under way” without specifying when that would be. Under that strategy, the central bank has been reinvesting principal payments from its bond holdings back into the market.
The debate over the Fed’s balance sheet will heat up during the Trump presidency, with about $1.2 trillion of its stock of Treasury securities set to mature from 2017 through 2020.
Yellen has defended the Fed’s asset purchases, arguing that they helped lower long-term interest rates, spurring economic growth and reducing unemployment in the process.
“Our purchases of Treasury and mortgage-related securities in the open market pushed down longer-term borrowing rates for millions of American families and businesses,” she told the Fed’s annual Jackson Hole, Wyoming conference on Aug. 26.
Some former Fed officials, though, have been critical of the central bank’s stance.
In an April 29 presentation that Malpass spoke approvingly of, Peter Fisher told economists at an event in New York that the Fed had discouraged banks from lending money by flattening the yield curve with its bond purchases.
“When yield curves steepen, lenders profit from wider net-interest margins between borrowing short and lending long,” said Fisher, who worked at the New York Fed from 1985 to 2001 and is now a senior lecturer at Dartmouth University. “This provides a powerful incentive to engage in maturity transformation and expand the supply of credit.”
Fisher, a former Treasury official in the George W. Bush administration who is not on Trump’s advisory team, said in a telephone interview Tuesday that the Fed should allow its balance sheet to shrink by not reinvesting the proceeds of debts it holds when they mature. That would encourage banks to lend more.
He said outright asset sales by the Fed would not be a good idea now, given the steepening of the yield curve that has already taken place in the wake of Trump’s election victory.
“The results of Fed policy have been highly disappointing,” Malpass said. “The Fed needs to have independence but get results that are more consistent with a growing economy.”
By Rich Miller