The Federal Reserve Will Never Be Dull Again
Much is being made of the Federal Reserve beginning to normalize its policy. It sounds as though the Federal Reserve is getting back to its old, boring self. While labor market progress is debatable with too many part-timers and a low participation rate and inflation remains subdued, the Fed is set to cease its quantitative easing (QE) stimulus program. The federal funds rate or “fed funds”, the primary tool of monetary policy, is set to re-emerge as the favored instrument. The Fed will wind down QE in October, and begin to raise interest rates sometime thereafter. The theory being that the US economy can support normalized policy without stumbling—at least too much. It seems the Fed will once again become the dull and subtle institution.
But this is simply not the case. Monetary policy is not going to be “normal”—and the Fed is not going to be boring, dull or subtle—anytime soon. At nearly 0 percent, the fed funds rate must move much higher to reach pre-recession levels. From January 1993 (the trough in fed funds after the 1990 recession) through the end of 2007 (before the Fed dropped it to nearly 0), the monthly average was about 4.4%. This would be no small move from current levels. The Fed itself sees rates of around 4 percent in the longer run, but does not agree on how quickly to move towards it. The Fed is also up against the downward trend in the fed funds rate since the late 70’s, early 80’s inflation was broken—each business cycle saw increasingly lower Fed Funds to combat an economic slowdown, and lower peak rates to cool an expansion.
Aside from the time it will take to move Fed Funds back to a more normal level, the side-effects of quantitative easing will take time to work out. The Fed’s balance sheet is currently sitting at about $4.4 trillion as QE led to the rapid accumulation of assets. The Fed should stop adding to its stockpile soon, but that does not imply that it will stop its purchases.
Much attention has been paid to how quickly the Fed purchased additional assets, but little given to the “rolling of maturities”. The Fed is currently maintaining the size of its balance sheet by purchasing new securities with the proceeds of those that mature. This keeps the balance sheet the same size, but does not increase it. A critical part of Fed guidance will be how quickly—if at all—they shrink the balance sheet. There are options. The Fed could stop rolling entirely, roll a portion, maintain the current policy and allow the balance sheet to stay large, and tweaking around the amount of mortgage-backed securities and treasuries among other options. The Fed has stated it intends to reduce the balance sheet to only what is necessary to operate, will hold mostly treasuries, and will let them roll-off, but has not provided guidance on when or how rapidly. The key here is that the Fed will be purchasing securities after it “ends” its QE program—just not growing the balance sheet.
It is worth asking whether Fed policy will ever approach something equivalent to a historical norm. For the moment, the answer appears to be no—at least for a very, very long time. Even if the Fed is able to raise fed funds moderately over the next couple years, it is unlikely it will be able to move them higher quickly enough to get them “off the ground” in any real way. There is also the question of how effective monetary policy can be in this type of environment. If there is a shock to the economy in 2016 and the Fed Funds rate is sitting at 1.5%, how will the Fed react? With little room to move rates lower, the Fed would likely resort to QE or halt shrinking the balance sheet (or both). Unconventional monetary policy is becoming much more conventional.
The Fed is nearing the conclusion of its latest round of QE, but this does not mark the end of an era. The balance sheet will remain inflated for a long time—even if an effort is made to reduce it. The balance sheet will become a more important tool of monetary policy (shrinking the balance sheet is a form of relative tightening). QE will likely be used in the future to stimulate the economy as moving the fed funds rate has less of an effect. A once simple to understand institution—moving interest rates up or down—has become an increasingly difficult one to understand. Monetary policy may someday return to the simplicity of old, but normal will not return anytime soon.
Image: Flickr/Creative Commons.