If you thought, like I did, that US Federal Reserve chair Jerome Powell was looking for a way out of being brow-beaten by President Donald Trump recently, it seems we’d be at least a little inaccurate in the assumption.
The president wanted no path to higher interest rates – after all, one immediate effect of doing that would be to push federal debt even higher than the $US22 trillion it’s just reached.
Mr Trump was also concerned at continued Fed normalising of its balance sheet, which would mean continuing to reduce its holdings of Treasury securities. The big effect of that would be to slow the economy.
In a speech delivered on Thursday in California, Mr Powell said the Federal Reserve’s open market committee (FOMC) was near the end of its path to normalisation and was now considering – and seeking views on – its path from here.
From the end of 2008 until the end of 2014, the Fed created money to buy $US3.7 trillion in longer-term Treasury & agency securities, which it then sold. From late 2017, the Fed began its programme of quantitative tightening, eventually repaying about $US50 billion/month as securities came due, so it’s a long way short of paying the whole lot back.
However, as Mr Powell’s first graph in his Stanford Institute address shows (above), his focus has been on percentages of gross domestic product. The Fed’s total liabilities stood at 5.9% of gdp in 2006, rose to 24.8% in 2014 and have since been reduced to 16.5%.
Reserve balances went from 0.1% of gdp in 2006 to 14.6% in 2014 and have fallen to 5.7%. Currency in circulation rose from 5.5% to 7.1% and continued to rise, to 7.9%.
11 paragraphs on normalising central bank debt
I’ve pulled out 11 paragraphs from Mr Powell’s address – a couple setting the scene, 3 on balance sheet normalisation, 2 on what the word ‘normalise’ means to the Fed and how it’s changed over the last decade, and finishing with 4 looking forward, not just at US central bank policy but at practices which are becoming accepted in various countries and are likely to lead to a new normal.
I’ve left footnote & graph pointers intact. If you click on them they’ll take you to Mr Powell’s footnotes, and you may find yourself returning from there to his full speech.
What to do when you’ve reached bottom?
“Just over 10 years ago, the Federal open market committee lowered the federal funds rate close to zero, which we refer to as the effective lower bound, or ELB. Unable to lower rates further, the committee turned to 2 novel tools to promote the recovery. The first was forward guidance, which is communication about the future path of interest rates. The second was largescale purchases of longer-term securities, which became known as quantitative easing, or QE. There is a range of views, but most studies have found that these tools provided significant support for the recovery. From the outset, the committee viewed them as extraordinary measures to be unwound, or ‘normalised,’ when conditions ultimately warranted….
“In some ways, we are returning to the pre-crisis normal. In other ways, things will be different. The world has moved on in the last decade, and attempting to re-create the past would be neither practical nor wise. As normalisation moves into its later stages, my colleagues & I also believe that this is an important moment to take stock of issues raised by the remarkable experiences of the past decade. We are therefore conducting a review of the Fed’s monetary policy strategy, tools & communications practices….
Balance sheet normalisation
“Between December 2008 & October 2014, the Federal Reserve purchased $US3.7 trillion in longer-term Treasury & agency securities in order to support the economy both by easing dislocations in market functioning and by driving down longer-term interest rates. Consistent with the committee’s long-stated intention, in October 2017 we started the process of balance sheet normalisation. We began gradually reducing the reinvestment of payments received as assets matured or were prepaid, allowing our holdings to shrink. The process of reducing the size of the portfolio is now well along.
“To frame the discussion of the final stages of normalisation of the size of the balance sheet, it is useful to consider what the phrase “normal balance sheet” meant in the decades before the crisis. During that period, the main monetary policy decision for the FOMC was choosing a target value for the federal funds rate. Subject to that choice, the Fed allowed the demand for its liabilities to determine the size of the balance sheet. This is a feature of ‘normal’ that we are returning to: After normalisation, the size of the Fed’s balance sheet will once again be driven by the demand for our liabilities.
“To see what this means, consider figure 1, which shows the size of the Fed’s balance sheet through time, as measured by total liabilities. The values are stated as a percentage of the dollar value of gdp, or gross domestic product.1 Liabilities began to grow sharply at the end of 2008 and continued to increase until the end of 2014. Since that time, liabilities relative to gdp have fallen appreciably. To understand these changes, it is useful to focus on a snapshot of the balance sheet at 3 points in time: before the crisis, when the balance sheet was at its largest, and a rough projection for the end of this year (table 1).
Whatever, the balance sheet will stay big
“In 2006, the dominant liability was currency held by the public, and the dominant asset was Treasury securities. The Fed’s asset purchase programmes increased the balance sheet from just below 6% to nearly 25% of gdp by the end of 2014.2 Balance sheets must balance, of course, and the Fed issued reserves as payment for the assets purchased. This action pushed reserves to nearly 15% of gdp.
“The committee has long said that the size of the balance sheet will be considered normalised when the balance sheet is once again at the smallest level consistent with conducting monetary policy efficiently & effectively. Just how large that will be is uncertain, because we do not yet have a clear sense of the normal level of demand for our liabilities. Current estimates suggest, however, that something in the ballpark of the 2019:Q4 projected values may be the new normal. The normalised balance sheet may be smaller or larger than that estimate and will grow gradually over time as demand for currency rises with the economy. In all plausible cases, the balance sheet will be considerably larger than before the crisis.
Lower interest rates cemented in as the new normal
“Because interest rates around the world have steadily declined for several decades, rates in normal times now tend to be much closer to zero than in the past (figure 5).8 Thus, when a recession comes, the Fed is likely to have less capacity to cut interest rates to stimulate the economy than in the past, suggesting that trips to the ELB may be more frequent. The post-crisis period has seen many economies around the world stuck for an extended period at the ELB, with slow growth and inflation well below target. Persistently weak inflation could lead inflation expectations to drift downward, which would imply still lower interest rates, leaving even less room for central banks to cut interest rates to support the economy during a downturn. It is therefore very important for central banks to find more effective ways to battle the low-inflation syndrome that seems to accompany proximity to the ELB.
How to make it work
“In the late 1990s, motivated by the Japanese experience with deflation & sluggish economic performance, economists began developing the argument that a central bank might substantially reduce the economic costs of ELB spells by adopting a makeup strategy.9 The simplest version goes like this: If a spell with interest rates near the ELB leads to a persistent shortfall of inflation relative to the central bank’s goal, once the ELB spell ends, the central bank would deliberately make up for the lost inflation by stimulating the economy and temporarily pushing inflation modestly above the target. In standard macro-economic models, if households & businesses are confident that this future inflationary stimulus will be coming, that prospect will promote anticipatory consumption & investment. This can substantially reduce the economic costs of ELB spells.10Researchers have suggested many variations on makeup strategies.11 For example, the central bank could target average inflation over time, implying that misses on either side of the target would be offset.
“By the time of the crisis, there was a well established body of model-based research suggesting that some kind of makeup policy could be beneficial.12 In light of this research, one might ask why the Fed & other major central banks chose not to pursue such a policy.13 The answer lies in the uncertain distance between models & reality. For makeup strategies to achieve their stabilising benefits, households & businesses must be quite confident that the ‘makeup stimulus’ is really coming. This confidence is what prompts them to raise spending & investment in the midst of a downturn. In models, confidence in the policy is merely an assumption. In practice, when policymakers considered these policies in the wake of the crisis, they had major questions about whether a central bank’s promise of good times to come would have moved the hearts, minds & pocketbooks of the public. Part of the problem is that when the time comes to deliver the inflationary stimulus, that policy is likely to be unpopular – what is known as the time consistency problem in economics.14
“Experience in the US & around the world suggests that more frequent ELB episodes could prove quite costly in the future. My FOMC colleagues & I believe that we have a responsibility to the American people to consider policies that might promote significantly better economic outcomes. Makeup strategies are probably the most prominent idea and deserve serious attention. They are largely untried, however, and we have reason to question how they would perform in practice. Before they could be successfully implemented, there would have to be widespread societal understanding & acceptance – as I suggested, a high bar for any fundamental change. In this review, we seek to start a discussion about makeup strategies & other policies that might broadly benefit the American people.”
Attribution: Powell speech.