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Sudden attention on Fed's balance sheet policy throws its communications into disarray


THE Federal Reserve's best laid plan for a below-the-radar rundown of its US$4.1 trillion balance sheet has gone awry.

Rather than operating in the background as policymakers intended, the strategy has been thrust into the spotlight as investors and US President Donald Trump have attacked it for fuelling last month's stock market sell-off.

"The sudden and unwanted attention that market participants attached to balance sheet policy has thrown the Fed's communications on the topic into disarray," JPMorgan Chase & Co chief US economist Michael Feroli said in a recent note.

The risk is that could lead to renewed market turmoil as investors try to parse the Fed's plan for a draw-down that some consider more significant than policymakers do.

Chairman Jerome Powell will get a chance to explain the approach when he briefs reporters on Jan 30 after a two-day Federal Open Market Committee meeting in Washington. No change is expected in its strategy of reducing its bond holdings by a monthly maximum of US$50 billion. Interest rates are also seen being left on hold.

It is not only Wall Street that has wrong footed the Fed. Washington has too.

Republican lawmakers' criticism of the bloated balance sheet as inflationary has been drowned out by Mr Trump's attacks on the Fed's move to reduce it when price pressures are muted.

"Trump has done an extraordinary job of articulating" the market's unease with Fed policy at key points, said PGIM Fixed Income chief economist Nathan Sheets.

US central bankers have already re-crafted their message about unwinding quantitative easing in response to December's stock slump.

No longer do they say the reduction is on autopilot. Instead, they assure that the policy is not on a preset course and that they are prepared to alter balance sheet plans if necessary to keep the economy on track.

The trouble is that the new formulation leaves much unsaid and could sow more uncertainty.

"Fed officials' attempts to calm market panic over 'quantitative tightening' create further risk for confusion," TD Securities head of Global Macro Strategy Michael Hanson said in a note.

The chances of that happening are heightened by disagreement between the Fed and market pros such as billionaire investor Stanley Druckenmiller over how consequential the unwind is. Central bankers just do not buy the argument that it sparked the fourth quarter stock sell-off.

"We don't believe that our issuance is an important part of the story of the market turbulence," Mr Powell said on Jan 4. He instead pointed to investor concerns about slowing global growth and US-China trade negotiations.

Morgan Stanley chief US economist Ellen Zentner and her team forecast that the balance sheet rundown will end in September.

Mr Powell, though, recently suggested otherwise. The future balance sheet "will be substantially smaller than it is now", he said on Jan 10, sparking a brief drop in shares.

To avoid misconceptions about its strategy, the Fed in 2014 issued what it called its "policy normalisation principles and plans". Indeed, Mr Powell cited the initial principles on Jan 4 when he said that the Fed was ready to change its strategy if needed to meet its goals.

But he failed to mention an augmentation of the plans agreed in 2017. It stated that the Fed would be ready to stop cutting its bond holdings "if a material deterioration in the economic outlook were to warrant a sizable reduction" in short-term rates.

That wording itself was confusing. It suggested that the Fed "could be putting one foot on the brake and the other on the accelerator" when it starts cutting rates, said Ethan Harris, head of global economics research at Bank of America Merrill Lynch. BLOOMBERG