from the St Louis Fed

— this post authored by James Bullard

As a consequence of the financial crisis, Great Recession of 2007-09 and sluggish economy that persisted for several years beyond that, the Federal Open Market Committee (FOMC) took extraordinary actions to stimulate the economy and promote the recovery.

By December 2008, for instance, the FOMC had reduced the federal funds rate target (i.e., the policy rate) to near zero – exhausting its conventional monetary policy tool. With the economy still weak and to guard against deflation, the FOMC turned to unconventional monetary policy, including three rounds of large-scale asset purchases from late 2008 to late 2014. The purchases were primarily of longer-term Treasuries and mortgage-backed securities. This policy, better known as quantitative easing (QE), led to an expansion of the Fed’s balance sheet.

Fast forward to today. The Fed’s goals for employment and inflation have essentially now been met. The FOMC’s focus has shifted to monetary policy normalization, including increasing the policy rate, which it has done three times since December 2015. With this return to more conventional monetary policy now underway, the question of how and when to begin normalizing the Fed’s balance sheet is timely.

As a result of the three QE programs, the Fed’s balance sheet increased from about $800 billion in 2006 to about $4.5 trillion today.1 The FOMC’s reinvestment policy, which includes replacing maturing securities with new securities, is keeping the balance sheet at its current size. If the FOMC wanted to begin shrinking the balance sheet, the most natural step would be to end the reinvestment policy. Ending reinvestments would lead to a gradual reduction in the size of the balance sheet over several years.

In recent months, I have been an advocate of ending reinvestments for two main reasons. One is that current monetary policy is distorting the yield curve. While actual and projected increases in the policy rate are putting upward pressure on short-term interest rates, maintaining a large balance sheet is putting downward pressure on medium- and long-term interest rates. Of course, interest rates are volatile and are affected by many factors, but raising the policy rate would normally tend to raise interest rates all along the yield curve. Therefore, a more natural way to normalize interest rates would be to allow all of them to increase together.