The Federal Reserve’s Balancing Act

A decade after the global financial crisis, the U.S. economy seems to be on its feet. Unemployment has reached 15-year lows and inflation has remained stable. This achieves the so-called dual mandate of the U.S. Federal Reserve, which seeks to keep people employed while holding prices in check.

But the Fed always faces a tricky balancing act. On one hand, there is a need to unwind years of easy money that has bolstered the economy since the 2009 recession. Move too slowly and inflation can get out of control. On the other hand, moving too quickly to normalize monetary policy can be problematic as it can send the economy back into recession.

The Fed’s task of normalizing monetary policy has been outlined extensively over the last few years. In its “Policy Normalization Principles and Plans,” presented in September 2014, two key elements are outlined:

  1. Steadily increase short-term interest rates
  2. Gradually reduce the size of the Federal Reserve balance sheet

The Fed originally lowered interest rates to make it cheaper to access credit, stimulating the economy by volume. This policy is beneficial in the short-term, as it makes it easier for new homeowners to afford mortgages and for businesses relying on credit to fund new investment, hiring, and payroll. In the long-term, however, low-interest rate policies hurt savers and especially the older demographic since more Americans receive interest through savings than pay interest through loans (excluding the government).

Policy normalization officially started in December of 2015, when we saw the first interest rate increase since the 2008 recession. After the first rate rise, the Fed waited until December of 2016 to raise rates again. Then they raised rates three times in 2017, up to a Fed Funds Rate of 1.25%-1.5%.

The second element of policy normalization involves reducing the size of the Fed’s balance sheet. Due to asset purchase programs initiated in order to inject liquidity into the market, the Fed’s balance sheet ballooned from pre-recession levels of $900 billion in 2008 to a peak $4.5 trillion in January 2015.

The balance sheet has slowly decreased since then and sits at $4.37 trillion as of February 8th. To gradually and predictably unwind these assets, the Fed has elected to reduce reinvestment of securities as they mature. There is no set target on where they want balance sheet assets to be since that is dependent on the banking system’s demand for reserve balances as well as the economic climate at any given time.

As the Fed pursues policy normalization, keeping inflation in check will remain important. If we see high inflation, that could force the Fed to raise interest rates more aggressively to moderate inflation. If the rate rises are too aggressive, it could slow down the economy as a whole. While interest rates are not the only tool the Fed uses to keep a lid on inflation, it still plays a major role.

The new chairman, Jerome Powell, has shown he is aware of the tightrope the Fed must walk and is widely expected to continue the gradual normalization policies of his predecessor.

As we have mentioned before, we see the definition of economic recovery as not only reaching America’s potential GDP (or the highest level of growth that can be sustained over the long-term) but also as the American economy weaning itself off of monetary policy tools that help the economy rebound when needed. Once the economy is operating with minimal Fed support, we can rest assured that those monetary policy tools will be available if, and when, we call on them again.