The famous Irish playwright, Oscar Wilde, once said “life imitates art”. Wednesday’s release of the Federal Open Market Committee minutes from the March 15 meeting encapsulates that thought.
In the May 12, 1994 episode of “Seinfeld”, George Costanza struggles to explain about “shrinkage” after going for a swim.
The FOMC is also struggling to explain shrinkage, specifically balance sheet shrinkage. It was discussed at length, according to the March 15 minutes, and news of the discussion caused a bit of a kerfuffle in FX markets.
There are plenty of reasons for financial markets to be concerned about when and how the Fed reduces its $4.3 trillion balance sheet. For one, poor execution would destabilize markets world-wide.
Simply put, halting the Fed’s practice of “rolling over “matured mortgage back securities and treasuries would put upward pressure on interest rates. That’s because it removes a big buyer from the market. Rates may need to rise to attract new buyers. Another issue is that if the “shrinkage” occurs while the Fed is still raising the Fed funds target rate, it risks choking off economic growth and causing a recession.
Former Fed Chair, Ben Bernanke wrote an article “Shrinking the Fed’s balance sheet” on January 26, 2017, making the case that the Fed is likely to defer action on the balance sheet until short term rates are meaningfully higher. By doing so, he said, the Fed gives themselves a lot of room to offset unanticipated effects.
The March minutes show that, many on the Committee believe that the timing for reducing the balance sheet should depend on qualitative judgement about broader economic and financial conditions. The Fed Chair may be one of them.
Janet Yellen is very cautious. Markets saw that in 2016 when the FOMC forecast four rate hikes. Only one was delivered. The decision to reduce the balance sheet is even more momentous. It hasn’t been done before on this scale and the economic consequences are unknown.
Ms. Yellen is unlikely to hurry this decision so in the short term, FX direction will continue to be driven by the pace of US rate hikes and Eurozone monetary policy.
The European Central Bank (ECB)is another major central bank grappling with “shrinkage” and when to proceed. On March 9, the ECB discussed ways of exiting from their quantitative easing program and the possibility of increasing interest rates. The news triggered a rally in EURUSD. It intensified after ECB President Mario Draghi didn’t refute the conclusions.
However, that was March. This is April. It is obvious that ECB officials did not like the conclusions that financial markets had drawn. ECB officials including President Draghi, Chief Economist Praet and Vice-President Constancio have spent the past few days stressing that ECB policy has not changed. They have all noted that measures of inflation are subdued and that their projections for inflation are dependent upon the existing policy. The ECB policy meeting minutes indicate that rate hikes were discussed but one official, Erkki Liikanen, dismissed the talks saying “there are lots of opinions on the governing council.
EURUSD has retreated from its March 27 peak of 1.0904 but it remains well-above the March ECB press conference low.
The Organisation of Petroleum Exporting Countries (Opec) has a contradictory shrinkage issue. World-wide crude inventories are not shrinking, despite Opec production cuts of 1.8 million barrels per day since January 2017. In the US, the Energy Information Administration, (EIA) reported that for the week ending March 31, 2017, “over the last four weeks, crude oil imports averaged over 7.9 million barrels per day, 2.3% above the same four-week period last year”.
There is a report that Iran is planning to increase its production by 600,000 barrels per day by the end of the year, which won’t make Opec happy. The cartel is already in discussions about extending the existing production cut agreement to help mop up excess global inventories. Iran’s plans will make that task more difficult.
The US Federal Reserve, the European Central Bank and Opec have shrinkage issues. Markets have a right to be concerned with how these organizations undertake the process because mismanagement will certainly destabilize global financial markets. Stay tuned.