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How Is Normalization of Monetary Policy Going to Work?


Monday, August 3, 2015
inflation expectations and fed credibility
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Each issue of The Regional Economist, published by the Federal Reserve Bank of St. Louis, features the section “Ask an Economist,” in which one of the Bank’s economists answers a question. The answer below was provided by Vice President and Economist Stephen Williamson.

How is normalization of monetary policy going to work?

Monetary policy normalization refers to the steps the Federal Open Market Committee (FOMC)—the Federal Reserve's monetary policymaking body—will take to remove the substantial monetary accommodation that it has provided to the economy since the financial crisis began in 2007. The committee has made it very clear that normalization is going to be data-driven. In other words, policy decisions will be based on the future performance of inflation, labor markets and gross domestic product (GDP), among other things.

In its "Policy Normalization Principles and Plans," announced in September 2014, the FOMC laid out a program that would ultimately allow the Fed to conduct monetary policy in essentially the same way it did before the beginning of the financial crisis. The principles and plans outline a sequence of actions by which normalization will be achieved:

  1. "Liftoff"—The FOMC will raise its interest rate target when it deems there is no longer as great a need for monetary accommodation. Liftoff is expected to happen sometime later in 2015, but, again, the timing of liftoff will be data-driven, not calendar-dependent.
  2. End "reinvestment"—The FOMC wishes to ultimately reduce the Fed's balance sheet to a size such that the quantity of interest-earning liabilities (including bank reserves) is small, as was the case before the financial crisis. Reinvestment is the process of replacing assets on the Fed's balance sheet as they mature; so, when reinvestment ends, the balance sheet will begin to shrink. 
  3. Shrink balance sheet—Balance-sheet reduction will occur slowly, with no plans to sell assets, though this option has not been ruled out. The Fed's assets will decline as Treasury securities and mortgage-backed securities (MBS) mature. While Treasuries mature at a predictable rate, MBS do not, as this depends on the rate at which the mortgages backing the MBS are refinanced and on mortgage defaults.

Federal Reserve Board economists estimate that the normalization process will take about seven years once it starts.

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