Desmond Lachman warns in a U.S. News column that no one really knows what’s likely to happen when the Federal Reserve reverses course.
Perhaps as early as September, the Fed plans to start reducing its balance sheet by $10 billion each month by not reinvesting the proceeds of its maturing holdings of U.S. Treasury bonds and mortgage backed securities. Once the unwinding process begins, the Fed plans to increase that amount over a 15-month period according to a pre-announced schedule to finally reach $50 billion a month in all probability by the end of 2018.
Fed Chair Janet Yellen assures us that once the process of reducing the Fed’s portfolio gets underway, it will be as dull as watching paint dry. However, the truth of the matter is that she cannot possibly know what will happen once the Fed goes down this uncharted path. We simply have no historical experience of what happens when the Fed starts to reduce its balance sheet after having increased it on anywhere near the scale it has done over the past eight years.
A clear risk that Yellen seems to be downplaying is that the Fed’s past policies of aggressive money printing, along with those of the world’s other major central banks, might have spawned large asset and credit market bubbles across the globe. These central banks are all too likely to have done so by expanding their balance sheets by a cumulative $10 trillion since 2008 and by effectively forcing investors into higher risk activities. They did so by reducing the supply of low-risk government bonds available to be bought in the market and by substantially reducing the interest rates that investors could get on those bonds.
Sadly, there are all too many indications that the Fed together with its counterparts abroad might have landed us yet again in a global asset and credit market bubble, much as they did in the run-up to the September 2008 Lehman crisis.
