The Fed is Itching to Normalize
With U.S. inflation below and diverging away from the 2% Fed target and no observable signs that inflation pressures are building, why is the Federal Open Market Committee (FOMC) of the Federal Reserve System (Fed) considering raising, this year, its target range for the federal funds rate by a quarter percentage point to 0.25–0.50% from today’s 0.00-0.25%? I think because the Fed is itching to normalize.
Let me start by defining what I mean by normalize. I do not mean adopt a tight monetary policy stance. I mean switch monetary policy regimes. The current regime combines the zero interest rate policy (ZIRP) with an outsized balance sheet. Normalizing means getting rates anywhere but zero—0.25% and above would be fine—and shrinking the balance sheet.
Recall that the Fed started blowing up its balance sheet during the crisis by buying up medium- and long-term debt securities (an asset for the Fed) and paying for them by crediting commercial bank deposits at the Fed (called reserves, and a liability for the Fed). These reserves the Fed created out of thin air. The idea was to stimulate demand for borrowing and risk taking by suppressing medium- and long-term interest rates and boost the supply of credit by pumping up commercial bank reserves.
Although late last year the Fed finished tapering off its program of asset purchases, it has not yet started to allow its balance sheet to shrink. The Fed can achieve balance sheet shrinkage passively, by refraining from replacing debt securities in its portfolio when they mature. Instead, it has kept on reinvesting principal payments in bonds comparable to those maturing. Thus, although via tapering last year the Fed gradually stopped adding new stimulus, it hasn’t yet removed the extraordinary stimulus previously put in place.
This current combination of ZIRP plus a balance sheet swollen to $4.5 trillion from its normal size of $800 billion is an extraordinary monetary policy regime built to ward off deflation. Now the Fed’s task is to switch from this extraordinary regime to a new normal one.
Let’s take a look at what this will entail. It will not entail a return to the pre-crisis regime, which involved the Fed’s announcing and steering money markets toward a single target federal funds target rate. Instead it will involve switching to a target range (no longer a target level) for the federal funds rate, adding two new interest rates at first, dropping to a single one later, and at some point starting to passively allow the balance sheet to shrink.
Normalizing will take years. The Fed has planned it meticulously and tested their two new instruments scrupulously; now they wait. I imagine Fed staffers to be chomping at the bit operationally. Also, I read in FOMC member speeches that they fret that inflation pressures not yet visible may erupt and before the FOMC has become agile at deploying its new tools. Members feel an urge to act, I think. And step one in acting is to revive the use of the federal funds rate by raising it a quarter percentage point. Just a quarter point is all that’s needed.
A thorny challenge lies ahead, however: how to communicate with markets about normalization so as to prevent an overreaction. Think back to tapering. The term referred not to tightening but rather to a gradually winding down of the monthly pace at which the Fed added new stimulus. Yet, to many market participants, tapering sounded like a euphemism for tightening. And, even for savvier ones, it spelled doom, as it meant that actual tightening now loomed closer. These thoughts triggered a tantrum.
But, just as tapering did not mean tightening, normalizing does not mean that the Fed will necessarily adopt a tight monetary stance any time soon. It will require a small lift up off the floor—25 basis points alone will do it. Beyond 25 basis points, in theory, the future path is data dependent entirely: normalization can lead to a tight stance but need not do so right away, not if macro conditions don’t warrant it.
This I think is what FOMC members mean when they urge us to stop obsessing over a mere quarter-point lift or the exact timing of that lift. But how to persuade markets of this? Three factors make it tough:
First, although the Fed has pilot-tested its two new tools—the interest rate on excess reserves (OER) and the rate on its overnight reverse repo rate (ON RRP) facility—markets correctly note that with these two new rates the Fed is moving into uncharted territory.
Second, this Brand New Toolkit for Normal Times that I’ve been describing here will be complex, involving three interest rates at first; later, two; and the use of a target range of rates rather than a single target level. Markets will need a learning period.
Third, implementation will subject markets to several historical firsts: an initial rate hike to a new target range with the introduction of two new rates to establish a corridor; a subsequent phasing out of one of the two new rates; then passive shrinkage of the balance sheet. Markets hate voyaging into the unknown.
I suspect that the Fed despairs of making this market-smooth—it figure it must simply take the plunge, explaining and illustrating as they go. Markets will writhe and yelp in discomfort at first, yes, but eventually “get it” and settle down, just as they did weeks into tapering.
I sympathize with (my imagined) Fed fretting that market reactions to liftoff probably will prove tumultuous in disproportion to the wee size of the first hike. Rate hike math captures this overreaction. Think of the current rate as simply 0%. Then, any hike, no matter how small, in percentage terms is infinitely large. We’re talking about regime change here; what mathematicians call a discontinuity.
In short, I think that the Fed can barely contain its urge to normalize. And that markets will think normalize means go all the way tight when in fact it means merely change tools. And so they’ll throw another tantrum.
This article paraphrases the author’s 1 September 2015 blog entry, I agree with Tim Duy but my reasons differ.
