Fed starts process to return to normal fund levels

Sept. 19 to 20 FOMC meeting

In a Nutshell: “In October, the Committee will initiate the balance sheet normalization program.” Decision: Fed funds rate maintained at 1.00 percent to 1.25 percent: Balance sheet normalization begun.

The great experiment of quantitative easing is over. The Fed calls the act of reducing its ownership of assets “balance sheet normalization” and it is to begin in October. This is important and we need to view the normalization of both the funds rate and the balance sheet as a dual process. The Fed considers quantitative easing to be a tool that ranks only just behind interest rate (fed funds rate) management.

The process of raising the funds rate to its normal level, which today’s report indicates to be roughly 2.75 percent, started in December 2015. Eleven of the 16 members expect another hike in December and at least three more next year. The funds rate normalization process is proceeding at a reasonable rate and should continue to do so, barring a major economic problem.

The second tool, quantitative easing/tightening, had yet to begin before this meeting. Before the financial crisis, the Fed’s balance sheet was below $1 trillion. Now, it is about $4.5 trillion. When interest rates approached zero, the Fed turned to asset purchases to increase liquidity in the system and keep the whole range of interest rates low. This was supposed to add to growth.

The consensus is that the Fed needs to shed somewhere in the range of $2 trillion to get to a “normal” balance sheet. The process, as outlined in June, is for this reduction to begin slowly so the Fed will start rolling off only $10 billion per month starting in October. That will slowly ratchet up to at maximum of $50 billion per month by the end of next year. But the process has a long way to go and it needed to get under way. Balance sheet reduction is expected to continue unabated, barring an economic crisis.

So, why is the Fed normalizing the levels of its tools? Inflation is still below its target and while the economy is near full employment, there may be room to for the rate to decline further. The answer is simple. The Fed’s quiver is largely empty. If the economy falters, does anyone believe the Fed can really add another few trillion dollars to its balance sheet? As for the funds rate, would a reduction of only one percentage point provide much policy impact?

The Fed needs to position itself so it can provide all the stimulus needed if the economy falters. That is their thinking now and it is why they have begun to reduce their balance sheet and raise rates. The members will move as quickly as reasonable, though the process could take over two years for the funds rate and as much as five or six years for the balance sheet.

The next FOMC meeting is Oct. 31 to Nov. 1, 2017.