The Federal Reserve’s new normal

The Federal Reserve has prepared investors for a small increase in interest rates this week, part of its effort to get monetary policy back to normal. The central bank should deliver the quarter-point rise the markets expect — but that isn’t all it ought
to do.
Investors’ attention is turning to a new question: What does the Fed intend to do about its balance sheet? The Fed needs to say more about when and how its holdings, which exploded under its program of quantitative easing, will be unwound. The interest-rate decision is straightforward. The economy is close to full employment. Though inflation has subsided a little recently, it stands close to the Fed’s 2 percent target. With unemployment low, pressure on wages is likely to increase. Monetary policy works with a lag, so the Fed has to think ahead. It makes sense to keep pushing interest rates gently back up.
The balance-sheet decision is slightly more complicated. It has three parts: The Fed must choose when to start shrinking its holdings, how quickly to shrink them once it has started, and how small the balance sheet should be when the holdings are back to normal.
The question of when to start will in part be dictated by the Fed’s interest-rate decision-making. The least disruptive thing for financial markets would be to let the process, once it’s begun, run its course through to completion, rather than requiring new decisions every month. To let that happen, the Fed must be in a position to cut interest rates if necessary. Interest rates will soon be far enough above zero for that condition to be met.
At that point, a phased-in run-off of bond holdings as they mature could be used to set the timetable. This would be predictable and gradual — better in both respects than shrinking the balance sheet through outright sales.
A harder question is how big the holdings ought to be once the process is deemed to have run its course. Before the crash, the Fed’s balance sheet was less than $900 billion. It now stands at some $4.5 trillion. Should it be squeezed all the way back?
The answer is no, for reasons well explained by former Fed chairman Ben Bernanke.
Currency in circulation, which accounts for part of the balance sheet, has gone up since 2007, and is likely to rise further as the economy expands. In addition, since the crash, the Fed has adopted a new way of steering interest rates, which for operational reasons requires a higher level of bank reserves. This, too, implies a bigger “normal” balance sheet. Exactly how big is less important than having investors know well in advance where the Fed stands. This coming policy shift isn’t yet imminent, because interest rates need to rise a bit more first. But it’s fast approaching, and this week isn’t too soon for the Fed to start being clearer about its intentions.

—Bloomberg