Quantity Easing in the US in its initial phases (Read QE1, QE2) had begun as an exercise where the FED was attempting to offset adverse credit market conditions. The lifeline of QE1 and QE2 was limited and predefined as consequentially when the program stopped pumping money the economic gains seem to disappear. Thus marked the advent of the subsequentprograms which were open ended and primarily a function of how real economic activity responded (read wage growth and job creation). Thus defines the setting that will mark the conclusion of the 6 year long zero lower bound interest rate policy.
One of the major aspect of the Large Scale asset purchase program that was pursued by the FED during the past 6 years is the expanding size of the central bank’s. As the following graph depicts, major central banks across the world have been experiencing inflating with the FED moving from a $900 Billion to $4.5 Trillion between 2006 and 2014.
Evolution of Central Bank Assets between 2007 and 2013, Image has been sourced from the FOMC report
While most analysts have been focussing on the ‘patient outlook’ communicated by the FED as a part of the Forward Guidance exercise it is important to understand the tools that will be used for normalizing monetary policy especially with respect toadjustments. This is particularly relevant for the reserve balances held by the FED. Prior to the crisis most central banks would hold reserves that would either fall short or exactly meet the requirements from the overnight funds market. Thus a slight tweak in the interest rates could have an amplified impact. However, with reserves ballooning from $25 Billion to $3 Trillion we are in a domain with excess supply thus the demand-supply interactions can no longer be relied upon to cause fluctuations in the interest rate environment.
In this scenario, the Interest paid on Excess Reserves (IOER) is an important tool to tune the Federal Funds Rate out of the ZLB ranges. The FED (as highlighted by Stanley Fisher) will increase the IOER and in turn promote banks to not lend at a rate lower than what can be availed via the IOER. Additionally, since not all banks have access to the IOER rate the FED will also use the channel of the Overnight Reverse Repurchase Agreement (ON RRP) to invest funds with the FED at an overnight rate (and thus making private institutions unwilling to lend in money markets with lower rates).
As far asnormalization is concerned, the FED highlights plans of not selling the asset backed securities instead ceasing reinvestments of principal payments on its existing securities holdings when the time comes.
As concluding thoughts, a critique of thepolicy might be inclined to think that accumulating bank reserves might have inflationary consequences through aggressive lending however, it is noteworthy to point out that this is a concern only under traditional assumptions when excess reserves receive no interest payments. Unlike the scenario here where excess reserves are eligible to earn interest.
So what are your thoughts on costs and consequences of this normalization policy?
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