“Now that the policy rate has been increased, the FOMC may be in a better position to allow reinvestment to end or to otherwise reduce the size of the balance sheet,” he said. “Adjustments to balance sheet policy might be viewed as a way to normalize Fed policy without relying exclusively on a higher policy rate path.”
In addition, he noted that current policy is distorting the yield curve. “The current FOMC policy is putting some upward pressure on the short end of the yield curve through actual and projected movements in the policy rate. At the same time, current policy is putting downward pressure on other portions of the yield curve by maintaining a $4.47 trillion balance sheet,” he explained. Bullard added that a more natural normalization process would allow the entire yield curve to adjust appropriately as normalization proceeds.
“The effects of balance sheet policy are uncertain, but are often attributed to a signaling effect that the FOMC intended to stay ‘lower for longer’ on the policy rate,” Bullard said. “That signaling effect may be important when the balance sheet is rising and the policy rate is near zero, but would not exist when the balance sheet is shrinking and the policy rate has moved away from the zero lower bound.”
He added, “As for the final size of the balance sheet, few would argue that the current $4.47 trillion level is appropriate. Ending reinvestment would still leave the balance sheet very large for years.”
Permitting some adjustments to the balance sheet may also create balance-sheet “policy space,” Bullard noted.
“Some have argued that the size of the balance sheet should not be reduced until the policy rate is high enough that the policy rate can be reduced appropriately should a recession develop. This is sometimes called ‘policy space,’” he explained.
Furthermore, the same “policy space” argument can be made for the size of the balance sheet, he said, adding, “we should be allowing the balance sheet to normalize naturally now, during relatively good times, in case we are forced to resort to balance sheet policy in a future downturn.”