An Unconventional Fed

After hiking interest rates four times in 2018 and signaling two more rate increases in 2019, Fed officials made an abrupt about face at their January meeting. Citing a growing number of “crosscurrents” emanating from a slowing global economy, Fed officials advocated for a “patient” policy stance and alluded to zero rate hikes in 2019. Perhaps more importantly, officials formally stated a willingness to stop shrinking the Fed’s balance sheet – a previously taboo idea. This last point has important implications and may mark a turning point in US monetary policy, where the Fed accepts the “unconventional” use of its balance sheet as a conventional tool going forward.

In normal times, the Fed’s conventional tool for conducting monetary policy is the federal funds rate. When the Fed wants to encourage economic growth, it cuts the federal funds rate; and when it wants to slow growth, it raises the rate. While the movement of the federal funds rate is important, what matters more is the magnitude in which it rises and falls – this is especially true when the Fed is facing a recession or crisis. In the past three downturns, the Fed dropped rates at least five full percentage points in an effort to support the economy.

To combat the financial crisis and Great Recession, the Fed dropped rates from 5.25 percent to near zero; however, even that move lacked the simulative oomph to pull the economy out of the doldrums. But, because the Fed had already pushed the federal funds rate to zero, there was little room left to maneuver. This forced the Fed to resort to unconventional monetary policy, which included using its balance sheet to make large-scale purchases of treasuries and mortgage-backed securities.

The Fed’s decision to purchase large amounts of treasuries and mortgage-backed securities (also known as “quantitative easing” or QE) was an attempt to put downward pressure on long-term interest rates. While it has been debated how effective the effort was, the result was that the Fed’s balance sheet ballooned from $800 billion to over $4 trillion. With the economy strengthening, the Fed has been attempting to shrink or “normalize” its balance sheet. However, the recent uptick in financial market volatility and fears over global growth have caused the Fed to reconsider just how low it is willing to let its balance sheet contract.

With the federal funds rate currently sitting in a range between 2.25 – 2.50 percent – too low to make a real impact if dropped – the Fed’s balance sheet is once again primed to take center stage as its go-to policy tool. If the economy deteriorates further, the Fed will likely need to resort to more large-scale asset purchases in order to stimulate the economy. A $10 trillion balance sheet could be the norm in the next few years.

The Fed’s use of unconventional policy during the financial crisis was widespread and frantic. The Fed used its balance sheet, but it also provided emergency funding to failing institutions. However, in backlash to the unprecedented moves, Congress later stripped the Fed of some of its powers. This episode showed that the Fed’s policymaking is not immune to Congressional oversight and that there are limits to how far it can stray from the traditional toolbox.

If the Fed is forced to look to its balance sheet to help manage the next downturn, it will likely face sharp criticism from Congress and the public. This public wrangling could impact the Fed’s ability to conduct monetary policy and limit its effectiveness in maintaining economic stability.