How will the FED normalize its monetary policy/balance sheet to the pre-crisis levels?

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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 subsequent QE programs 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 balance sheet. As the following graph depicts, major central banks across the world have been experiencing inflating balance sheet with the FED moving from a $900 Billion to $4.5 Trillion between 2006 and 2014.

http://www.federalreserve.gov/newsevents/speech/fischer20150227a1.jpg

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 to balance sheet adjustments. 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 as balance sheet normalization 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 the QE policy 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?

The content for the blog has been sourced using the following:

Conducting Monetary Policy with a Large Balance Sheet , What is quantitative easing?Why Are Banks Holding So Many Excess Reserves?

 

 

 

 

 

 

Comments (5)

Best Response
Mar 3, 2015

If you really want to answer your question, why do you think the fed's current plan to essentially let the securities mature would be a bad one? This seems like it will have a very minimal impact from a theoretical view (which is all we can have) compared to outright selling the BS down. The name of the game has continuously been "gradual" tightening, so it would seem wise to maintain some level of reinvestment so that maturation doesn't all happen at once. IIRC a lot of the BS was in the 10-15 year range for MBS and treasuries, so it would be wise to not let the market be flooded with new issuance's when they're no longer buying.

    • 2
Mar 3, 2015
FutureLRO:

If you really want to answer your question, why do you think the fed's current plan to essentially let the securities mature would be a bad one? This seems like it will have a very minimal impact from a theoretical view (which is all we can have) compared to outright selling the BS down. The name of the game has continuously been "gradual" tightening, so it would seem wise to maintain some level of reinvestment so that maturation doesn't all happen at once. IIRC a lot of the BS was in the 10-15 year range for MBS and treasuries, so it would be wise to not let the market be flooded with new issuance's when they're no longer buying.

+1

Mar 3, 2015

There will be more QEs' than Rocky movies.

Mar 3, 2015

Their balance sheet gives them huge leverage in the market, especially concerning repo operations. That gives you the strongest indication that not only are they comfortable with such a large balance sheet but it gives them another lever with which to move interest rates when they choose to. It also gives them another mechanism to pull/push liquidity into the marketplace as they want to. Considering that central banks fear deflation like the black plague, the more levers they have the merrier.

Generally, however, all that QE will end up doing is propping up the system and pulling forward more and more future earnings to pay for things coming due now for which there are no current reserves for. Such has become the nature of everything in pretty much every country around the world. We are all inflating, some more than others, to prop up an over-levered world economy which has gotten such a way over a few generations. It's normal now, and I don't think we are going back to the way it was anytime soon. Sure, we will see much higher rates again but I think the range for 'normal' has changed significantly.

Mar 3, 2015
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