Unconventional: A Policymaker's Reflections on Crisis to Recovery
"In late 2008, as the financial crisis escalated, the FOMC reduced the federal funds target rate as low as it could—essentially to zero. To foster economic conditions that would help the Fed achieve its dual mandate of stable prices and maximum sustainable employment, it also turned to other accommodative tools, primarily QE. This led to a huge increase in the Fed’s balance sheet. When it came time to determine the strategy for returning policy settings to normal, Jim Bullard made the case for a 'last-in, first-out' approach—i.e., reducing the balance sheet first before raising the policy rate."
—Cletus Coughlin, Senior Vice President and Chief of Staff to the President
James Bullard shared some reflections on his first 10 years as Bank president during recent conversations with staff. The following are excerpts from those discussions.
After the FOMC ended its QE3 program in the fall of 2014, the focus turned to when it would begin normalizing monetary policy. In December 2015, the FOMC voted to raise the policy rate from its near-zero level, which is commonly referred to as “liftoff,” as the first step in normalization; it has since raised the policy rate several more times. Some 21 months later, in September 2017, the FOMC announced that, beginning the following month, it would start the gradual process of reducing the Fed’s balance sheet, which had grown from about $870 billion in August 2007 to about $4.5 trillion as a result of quantitative easing.
The FOMC lowered the policy rate essentially to zero in December 2008 and implemented three QE programs over the next several years, which caused the Fed’s balance sheet to increase substantially. During normalization, the FOMC raised the policy rate first before beginning to shrink the balance sheet. The shaded area indicates a recession.
SOURCE: Board of Governors of the Federal Reserve System (data retrieved from FRED® on March 22, 2018).
The FOMC chose to raise the policy rate first before starting to shrink the balance sheet, but I favored the opposite sequence—a last-in, first-out (LIFO) policy. I thought there was a clear argument in favor of that approach.
The idea behind a LIFO approach to normalization is as follows. In easing monetary policy, the FOMC lowered the policy rate essentially to zero, the so-called zero lower bound. Because the policy rate couldn’t be reduced further, the FOMC turned to QE, which led to a substantial increase in the size of the Fed’s balance sheet. The asset purchases under the various QE programs included mostly longer-maturity Treasury securities and mortgage-backed securities, but also some federal agency debt. On the liability side of the Fed’s balance sheet, this meant an increase in reserves held by financial institutions. Once the economy had recovered sufficiently, the natural sequence of events, in my view, was to reduce the size of the balance sheet down to its normal size, and then to raise the policy rate back to its normal level.
In the sequence I have described, the amount of reserves in the system was initially low but then rose substantially because of the asset purchases. If the level of reserves were brought way back down again, then policymakers could run their operating procedure and could raise the policy rate the same way as in the past.1 I think that approach makes a lot of sense.
However, the FOMC decided to start slowly raising the policy rate first. Policymakers were constrained by the zero lower bound when reducing the policy rate, but they were not constrained by the zero lower bound when raising it. In other words, once the policy rate was near zero, the FOMC had to use unconventional policies, such as QE, to provide further monetary accommodation when needed. But during normalization, the FOMC could adjust both the policy rate and the size of the balance sheet. The FOMC chose to use the policy rate as the primary way to adjust policy.
I still believe shrinking the balance sheet first would have been the right approach to normalization. Doing liftoff first has forced the FOMC to raise the policy rate in a world of superabundant reserves. Because reserves are not scarce like they were before the crisis, the Fed has had to adopt new operating procedures for raising interest rates.2
In addition, raising the policy rate while maintaining a large balance sheet has led to some flattening of the yield curve. This is one reason why I argued in late 2016 and early 2017 to get going on shrinking the size of the Fed’s balance sheet. The FOMC’s interest rate policy was putting upward pressure on short-term interest rates, while the balance sheet policy was putting downward pressure on longer-term interest rates. A more natural normalization process would allow all interest rates to increase together. Although the FOMC began the process of gradually reducing the size of the balance sheet in late 2017, it remains important to keep an eye on the yield curve as monetary policy normalization proceeds.3