Economist LaVorgna: The Fed should raise rates to 2 percent and then just stay there

Federal Reserve Chair Janet Yellen speaks during a news conference December 13, 2017 in Washington, DC. Yellen announced that the Federal Reserve is raising the interest rates by a quarter point to 1.5%.
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Federal Reserve Chair Janet Yellen speaks during a news conference December 13, 2017 in Washington, DC. Yellen announced that the Federal Reserve is raising the interest rates by a quarter point to 1.5%.

The Federal Reserve"s balance sheet ballooned following the collapse of Lehman Brothers in September 2008 because of quantitative easing (QE). In August 2008, securities held outright at the Fed totaled $870 billion. By January 2015, this figured soared to a massive $4.46 trillion, an incredible increase of 413 percent.

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To put this into perspective, at one point, the Fed"s balance sheet as a share of GDP peaked at a stunning 26 percent and is now currently just under 24 percent. Prior to Lehman, the share was only 6 percent.

Then last September, Fed Chair Yellen and her colleagues on the Federal Open Market Committee (FOMC) announced their intention to allow the balance sheet to organically decline. Policymakers would accomplish this by simply reducing the amount of money that would be reinvested when various Treasury and mortgage securities matured.

Critically for financial market participants, the Fed laid out a schedule for these actions. It showed a very small initial reduction in the amount of money that would not be rolled over. By doing it this way, the Fed would minimize market disruption and lower the probability of a spike in long-term interest rates, which would have a significant adverse impact on the economy and financial markets.

Organic balance sheet reduction commenced the following month in October 2017. Initially, the Fed would rollover $6 billion less in Treasurys and $4 billion less in mortgages. Then every quarter, these limits would increase by $6 billion and $4 billion, respectively. Ultimately, they would cap out at $30 billion for Treasurys and $20 billion for mortgages. Again, this transparency was done to mitigate market disruption and volatility.

If the Fed continues to follow its script, the balance sheet could decline by upward of $420 billion this year. A more precise figure cannot be given because the amount of mortgages that are maturing due to prepayment speeds. If rates rise, there will be fewer mortgages that are refinanced. According to our own calculations, the amount of maturing securities this year could be as small as $325 billion, which is still a really big number.

The maturation of the Fed"s balance sheet has been dubbed quantitative tightening (QT), the inverse of QE. If the latter had a large positive effect on the economy through a suppression of interest rates, it is highly likely that quantitative tightening will possibly have a similar-sized but opposite impact. After all, the liquidity that was created through the Treasury and mortgage asset purchase program is being drained from the financial system. This could negatively impact the economy just as the asset purchases helped the economy. Indeed, this is what the Fed"s own work suggests.

According to analysis done by the Fed and subsequently referenced by Chair Yellen, the effect of the entire QE program was to reduce long-term interest rates by 120 basis points. We estimate that this is equivalent to approximately a 300-basis-point reduction in the fed funds rate. This is a substantial number to be sure, which leaves us wondering, "Why not let the anticipated reductions in the balance sheet do most of the Fed"s heavy lifting, especially when there is so little risk of an inflation breakout?"

Under this prudent approach, the Fed could lift the fund rate to 2 percent, which is close to the natural rate of interest and keep it there at long as core inflation stayed at 2 percent or less.

At the same time, the Fed can more actively manage its balance sheet. If the economic and financial outlook materially changes, FOMC policymakers could either accelerate or decelerate planned redemption. Given our projection of solid economic growth, the potential for a faster reduction in the balance sheet would more quickly bring its size back to a more normal level relative to the size of the economy. Whether it ever gets back to its pre-Lehman ratio is a topic for another day.

Joseph LaVorgna is chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the second-largest banking group in France with 31.2 million clients spread over two retail banking networks, Banque Populaire and Caisse d"Epargne