"The Fed Shrinking Its Balance Sheet and the Rising US Budgetary Deficit Make a Dangerous Cocktail"

As expected, the US Federal Reserve has made no change to the federal funds rate after raising it from 0.75 to 1.0 per cent back in March 2017. What has come to the fore of the debate surrounding monetary policy now is the timing and speed of the Reserve’s efforts to shrink the size of its balance sheet by reducing its stockpile of bonds. Professor Friedrich Heinemann, head of the ZEW Research Department "Corporate Taxation and Public Finance" at the Centre for European Economic Research (ZEW), offers his view on the matter.

"The next interest rate adjustment from the Fed is just a matter of time. As a result of President Trump’s planned tax cuts, which are not even being partially offset, there is a danger that the US budgetary deficit will expand drastically from 2018 onwards. This will speed up the rate at which the Federal Reserve raises interest rates.

When exactly the Fed is going to begin reducing its 4.5 trillion dollar stockpile of bonds is a thorny issue. Once again, the Fed has shied away from setting a date for this. That’s because the Fed’s plan to shrink its balance sheet and Washington’s sharply rising financing needs make a dangerous cocktail. The supply of US government bonds will increase significantly, leading to the risk of a sudden increase in the yields at the longer end of the term structure. This all offers the eurozone just a little taste of the problems which the European Central Bank is going to face when it exits from its non-conventional policy. It should serve as a warning in Europe that a swift end to the central bank purchases of bonds is needed."

For further information please contact

Prof. Dr. Friedrich Heinemann, Phone +49 (0)621/1235-149, E-mail heinemann@zew.de