Simon Potter: Gradual and predictable - reducing the size of the Federal Reserve's balance sheet Remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the Federal Reserve Bank of New York, at the SUERF - The European Money and Finance Forum Conference "Globalisation Dynamics - EU and US perspectives", New York City, 11 October 2017. * * * Thank you very much.1 I appreciate the invitation to speak to you as part of today’s SUERF conference on “Globalization Dynamics: EU and US Perspectives.” With events like these, the SUERF aims to foster an active network between professional economists, financial practitioners, central bankers and supervisors.2 Ongoing dialogue between these groups is important to the efficient and effective implementation of monetary policy, and I am glad to have the opportunity to make a small contribution to that dialogue. Just a few weeks ago, the Federal Open Market Committee (FOMC) announced that it would begin to passively reduce the size of its securities portfolio. This announcement marks the beginning of a multiyear effort to bring the Federal Reserve’s balance sheet to its longer-run size. In my remarks today, I’d like to offer my views on this policy from a financial markets perspective. The message I’d like to leave you with today is one of confidence. I am confident that the FOMC’s plan will reduce the size of the portfolio in a gradual and predictable, “no surprises” manner.
Recall that FOMC statements around the time of the taper tantrum stated that asset purchases would continue “until the outlook for the labor market has improved substantially in the context of price stability,” and it is possible that many market participants took the signal from an impending taper that the FOMC was less committed to the goal of a substantial improvement in the labor market than they had thought. Not only could this have affected some investors’ expectations for the balance sheet going forward, but it could have also affected views on the FOMC’s other policy tool: the overnight interest rate.23 A related possibility is that in the current situation expectations for a very gradual program of increases in the federal funds rate are relatively well entrenched, with liftoff more than a year and a half behind us. In 2013 market participants were focused on policies that would add more 9 / 15  BIS central bankers' speeches  accommodation. Under the “recruitment effect” proposed by former Governor Jeremy Stein and Sam Hanson of Harvard Business School, yield-oriented investors react to lower short-term rates by “reaching for yield” into longer-dated maturities, and reverse this effect when short-term rates rise. These effects can be even larger when balance sheet policies are in active use.24 As a result, a shock to expectations of the central bank’s reaction function can lead to outsized movements in longer-term rates.