Getting Back to Normal
By: Dr. M. Ray Perryman
Published in syndication April 12, 2017
It's been almost a decade, but the Federal Reserve (Fed) is finally confident enough in the economy to begin actions to get back to normal after the "great recession." This is good news, because getting the Fed's balance sheet back in order is essential to future economic performance.
As the global financial crisis unfolded beginning in 2007, the Federal Reserve stepped in to help lessen the fallout for the US economy (and, by extension, the rest of the world). Short-term interest rates were reduced to virtually zero in order to stimulate investment, and unconventional policy measures were also taken to try to drive down longer-term interest rates. To accomplish these objectives, the Federal Reserve (through the Federal Open Market Committee or FOMC) buys securities, thereby injecting money into the economy. Those actions were absolutely essential, as the global financial system was literally on the brink. After the worst of the situation passed, the Fed continued to stimulate the economy through a weak recovery period, a process that came to be known as "Quantitative Easing." The merits of this effort are more debatable, but the time for that discussion (other than within the halls of academia) has long passed.
The combination of lower interest rates and more liquidity helps get the economy going again by stimulating investment. However, it also leaves the Federal Reserve with a large portfolio of securities. Moreover, if interest rates are already low and liquidity is already high, the Fed's options are far more limited if the economy takes another tumble.
It's a delicate balancing act to bring things back to normal. If the Fed acts too quickly, the pace of growth and hiring could be negatively affected. If they act too slowly, inflation could ramp up (in addition to the other problems of a bloated balance sheet). Hence, the move toward normalization of monetary policy, which is the plan for bringing short-term interest rates and the Fed's portfolio back toward more typical patterns, must be managed with care.
Several years ago (September 2014), the FOMC released a very clear statement regarding how the normalization would occur when the economy was strong enough and the time was right, with more insight provided after various meetings. It is important that the Fed be crystal clear with these plans to avoid any nasty surprises for financial markets around the world.
The timing and pace of actions to raise the federal funds rate (and other short-term interest rates) to more normal levels and to reduce the Federal Reserve's securities holdings will be driven by the overarching statutory mandate of the Fed: maximum employment and price stability.
Over time, the stated intention is that the Federal Reserve will hold no more securities than it needs to implement monetary policy efficiently and effectively. Also, the plan is that primarily Treasury securities will be held in order to minimize the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy. At the moment, the Fed has several trillion dollars more than it needs, and many of them are invested in mortgage bonds. So the task is arduous indeed.
In December 2015, economic conditions were sufficiently improved for the FOMC to begin the process of normalization by raising the target range for the federal funds rate for the first time since December 2008. Subsequent mixed results in the economic data led the Fed to keep the rate at the level until the second increase in the target rate which occurred in December 2016. At the most recent meeting in late March, the rate was raised again. To put this in perspective, these three increases total 75 basis points (or 0.75%); between September 2007 and December 2008, there were 10 decreases which shifted the target rate from 4.75% to essentially zero. In other words, there is still a long way to go to get back to anything approaching pre-recession levels.
This will be a case of "slow and steady wins the race." The approach outlined in September 2014 was reaffirmed at the last meeting and the plan continues to be to reduce the Fed's security holdings in a gradual and predictable way, primarily by phasing out reinvestments of principal received from those securities. Most members of the FOMC agreed that changing the target federal funds rate range should be the primary means of adjusting monetary policy, and that reducing the size of the balance sheet should be accomplished in a predictable way. At the recent March meeting, it was indicated that the balance sheet part of the effort would likely start later this year.
The idea is that this gradual change in monetary policy will allow economic activity to continue to expand at a moderate pace so that labor market conditions will improve further while inflation remains in check. The actions taken by the Fed down the road will depend on incoming data and what it reveals about the current and likely future state of the economy. It is good to see the process of returning to normal underway, and as the balance sheet comes back into line over time, I and many of my peers who watch such things closely will be more at ease. The fact that the process is so transparent will help avoid shocks, and unless the economy experiences a major setback, the Fed's plan will see us back to normal without undue disruption. It should not be forgotten that even bringing up the balance sheet represents an enormous expression of confidence in the economy going forward, which is good news for all of us.