Unwind Federal Reserve balance sheet but keep rates low says Federal Reserve's James Bullard

Jasper Jolly
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James Bullard, president of the St Louis Fed, wants to end distortions to the bond market (Source: Getty)

The Federal Reserve should keep interest rates low but unwind its massive balance sheet, according to the head of the St Louis branch of the central bank.

James Bullard argued the Fed should end the distortion caused by its massive holdings on the relative prices of bonds with different maturities, known as the yield curve.

He said: “Ending balance sheet reinvestment may allow for a more natural adjustment of rates across the yield curve as normalisation proceeds.”

Read more: The Fed has hiked interest rates, but sent the dollar tumbling

The $4.5 trillion (£3.59 trillion) in securities currently held by the Federal Reserve places downward pressure on rates offered by longer-dated bonds by suppressing supply to the market. The lower supply raises bond prices, which move inversely to yields.

The low returns offered by longer-dated securities make the job of pension funds and other large asset managers harder by reducing the low-risk returns they can make.

The central bank bought the bonds during its quantitative easing stimulus programme which has since ended. However, the Fed has reinvested all payments from the bonds and rolled over maturing Treasuries to buy new ones. It insists it will do so until interest rate increases are "well under way".

However, Bullard, who will return on rotation as a voting member of the rate-setting Federal Open Market Committee (FOMC) in 2019, said the lower interest rate environment was tolerable.

Read more: Is the US economy ready for higher interest rates?

“The US economy has arguably converged to a low-real-GDP-growth, low-safe-real-interest-rate regime,” he said.

The combination of low rates and low growth means the “the Fed’s policy rate can remain relatively low while still keeping inflation and unemployment near goal values,” he said.

The Fed is tasked with maintaining price stability, with a two per cent target for inflation, while not damaging employment levels.

That task could be complicated by the new administration. US President Donald Trump’s campaign platform included promises to slash tax and regulation and invest heavily in infrastructure, all of which would likely promote growth.

Read more: Janet Yellen sets course for rate rises if economy performs well

“The new fiscal policy could impact productivity growth and therefore improve the pace of real GDP growth,” Bullard said.

Any growth in productivity could increase the rate of return on real assets, pressuring the Federal Reserve to raise interest rates in response.

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