Academic journal article Review - Federal Reserve Bank of St. Louis

Monetary Policy Normalization in the United States

Academic journal article Review - Federal Reserve Bank of St. Louis

Monetary Policy Normalization in the United States

Article excerpt

The Great Recession, which began in late 2007 and continued until mid-2009, demarcates some key changes in U.S. monetary policy. In 2015, the Federal Reserves balance sheet is much larger than before the Great Recession. From December 2007 to October 2014, the Fed's balance sheet (either total assets or total liabilities, which are equal) increased more than fourfold. Since late 2008, the Fed's target interest rate, the federal funds rate, has been close to zero. This long period of a zero interest rate policy, or ZIRP, is unprecedented since the Treasury-Federal Reserve Accord of 1951 modernized the approach to central banking in the United States.

In its "Policy Normalization Principles and Plans" (Board of Governors, 2014), the Federal Open Market Committee (FOMC) proposed a program that should ultimately return the Fed's balance sheet to a state similar to that of December 2007. This does not literally mean a return to a balance sheet of the same nominal size (in U.S. dollars) as before the financial crisis, but to a balance sheet that allows the Fed to implement monetary policy in the same way it did in December 2007, as discussed later in this article. In addition, the FOMC s principles and plans outline a sequence of actions by which "liftoff"-departure from a ZIRP-would be achieved, followed by a reduction in the size of the Feds balance sheet.

The purpose of this article is first to take stock of the state of U.S. monetary policy and how that state was reached. This discussion is followed by an analysis of how the FOMC envisions normalization and the pitfalls that may arise on the road to normalization.

UNCONVENTIONAL MONETARY POLICY AND ITS LEGACY

There are two key aspects of the Feds monetary policy that should be considered: (i) the size and composition of the Feds balance sheet and (ii) the Feds interest rate policy. Each of these is analyzed in turn.

The Size and Composition of the Fed's Balance Sheet

Figure 1 summarizes the time series of items on the assets and liabilities sides of the Feds balance sheet from 2007 to the present. Clearly, there has been a remarkable increase in the size of the balance sheet since the period prior to the financial crisis. (The critical period of the financial crisis period is defined here as the fall of 2008 through early 2009). For example, total assets held by the Fed increased from $891 billion in December 2007 to $4,498 billion in December 2014, a more than fourfold increase-or, alternatively, an increase from 6.1 percent of annual gross domestic product (GDP) to 25.3 percent of GDP.

While the size of the Fed's balance sheet has increased greatly since the Great Recession began in December 2007, such an increase is by no means unprecedented, nor is it a world record. For example, at the end of September 2014, the Swiss National Bank, the Bank of Japan, the Peoples Bank of China, and the National Bank of Denmark held assets that were, respectively, 80.1 percent, 57.0 percent, 52.3 percent, and 26.3 percent of GDP, while the Fed held assets that were only 25.3 percent of GDP. Of course, at that time, the Fed's balance sheet was larger than those of some central banks: Bank of England (22.5 percent of GDP), the European Central Bank (20.2 percent), the Swedish Riksbank (12.1 percent), the Reserve Bank of Australia (8.9 percent), and the Bank of Canada (4.6 percent).

It is important to note that much of the increase in the size of the Fed's balance sheet has occurred since the Great Recession ended in June 2009, when the Fed's assets stood at $2,026 billion, or 14.1 percent of GDP. Further, the sources of the increases on the asset side of the Fed's balance sheet during the Great Recession were quite different from the sources after the Great Recession. As shown in Figure 1, much of the increase in the Fed's assets during the Great Recession resulted from its lending programs-both conventional and unconventional-and purchases of troubled assets and commercial paper. …

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