Fed has the tools to avoid bubbles
Letter to the Editor

Sir,

Benjamin Friedman’s concerns about the return of the Federal Reserve’s balance sheet to a more normal size would seem to be misplaced as a pressing policy concern for two basic reasons (“The perils of returning a central bank balance sheet to ‘normal’”, June 20).

The first is that, in the context of a lacklustre US recovery, it is difficult to envisage a scenario under which the staggering increase in the Fed’s balance sheet could reasonably be reversed within the next few years. Over the past five years, the Fed’s balance sheet has ballooned to $4.3tn and the Fed is still adding to that balance sheet, albeit at a diminishing rate. Even if one were to assume that once ended and the Fed started selling long-dated bonds at a $50bn monthly rate, it would take more than five years for the balance sheet to return to a more normal size.

The second reason is that, contrary to Mr Friedman’s assertion, besides short-term interest rates and longer-dated bond purchases and sales, the Fed does have at its disposal a range of macroprudential policy instruments. These instruments – which include the setting of underwriting standards, reserve requirements, loan to asset ratio requirements, stock margin requirements and supervisory pressure – might be used to influence the sector flow of credit and to avoid the recurrence of particular asset price bubbles. And they might do so in much the same way as asset sales from the Fed’s balance sheet.

Desmond Lachman, American Enterprise Institute, Washington DC, US

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