Will The Fed And U.S. Monetary Policy Ever Get Back To ‘Normal’?

In its quest to save the U.S. economy during the financial crisis, the Federal Reserve went where it had rarely — or even never — gone before. The central bank slashed the target for its key short-term interest rate, the federal funds rate, to nearly zero and pumped a record $2 trillion into the economy by buying troubled mortgage-backed securities and other assets, ballooning its balance sheet more than four-fold. Now, as the economy seems to be finding solid footing, the Fed is looking to resume historically normal, pre-Great Recession operations.

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But can it do so, or is this a new normal? “The Fed has, post-2008, become a vastly more complicated place,” notes Wharton professor Peter Conti-Brown, author of The Power and Independence of the Federal Reserve. “This means that the Fed is much more than a monetary policymaker, but is also sitting in the big chair for all systemic risk and financial stability regulation and supervision, both before and after financial crises. In that sense, the central bank world before 2008 no longer exists and will never be restored. The [financial] crisis has made sure that the Fed will be a prominent player in economic policymaking for the indefinite future.”

The Fed’s plan to return to normal consists of raising interest rates to pre-Great Recession levels and whittling down its balance sheet, with the pace dependent on U.S. economic performance. But Conti-Brown says “the full extent of the Fed’s normalization plan is pretty sketchy. All we know is that most members of the [Fed’s] FOMC (Federal Open Market Committee) are eager to see interest rates return to higher levels, but they’ve been similarly eager for several years. There is no general consensus on how the Fed should unwind its balance sheet, although several members of the FOMC have suggested that they would like to see this occur throughout 2017 and 2018. We are, as we have been, in a tentative space that depends on an uncertain future.”

At least, the Fed is moving cautiously. “Moving too quickly could undo much of what the economy has already accomplished,” Conti-Brown notes. Rushing back into “a world where the Fed has a less than $1 trillion balance sheet, with interest rates in the 3% to 4% range, could deal a serious blow to the fragile, if not very long, economic recovery.” He notes that Fed critics want the central bank to move more quickly in case inflation surges. While inflation is currently under control, Conti-Brown says, their argument is that it might still spike. “Navigating these concerns makes the world of central banking in 2017 a very fraught exercise.”

“The [financial] crisis has made sure that the Fed will be a prominent player in economic policymaking for the indefinite future.”–Peter Conti-Brown

Tayyeb Shabbir, Wharton adjunct professor of finance, agrees that the Fed under Chair Janet Yellen “seems to be moving at just the right speed.” But Shabbir, whose last book on financial crises was co-edited by Nobel Laureate and Wharton economist Lawrence Klein, sees a new normal coming. “Monetary policy will regain its normal functionality; expectations of consumers, investors and all economic agents in general will return to ‘normal’ — which may not be the exact reversion to the pre-crisis level but it will be normal in terms of … functionality.” But there will be a residual effect. “Having hit the gas pedal to the floor once, albeit for a protracted time, should not preclude it [from] working more ‘normally’ once the extreme conditions have disappeared,” he adds. “However, war wounds may heal, but scars are left behind.”

The Fed’s Unorthodox Actions

Buoyed in part by low interest rates, the U.S. housing market started flourishing in the 1990s and accelerated in the mid-2000s before reaching a peak in 2006, seeing a boom in construction, home prices and credit. According to the Federal Reserve Bank of Richmond, “average home prices in the United States more than doubled between 1998 and 2006, the sharpest increase recorded in U.S. history.” More consumers borrowed money to buy homes: Mortgage debt rose to 97% of GDP in 2006 from 61% in 1998.

Typically, people with poor credit — subprime borrowers — had a tougher time qualifying for mortgages. But during the housing bubble, many more mortgages were being taken out and repackaged into complex securities, then sold off to investors. Thus, the risk of lending to borrowers shifted away from the bank or mortgage lender. This led to lenders qualifying more subprime borrowers for home loans, particularly into adjustable rate mortgages; when rates reset they refinanced or took out another mortgage. This pushed up home prices to sometimes stratospheric levels.

But the gravy train couldn’t last forever and mounting defaults on mortgages put heavy pressure on banks and institutional investors who bought these securities. (These securities were so complex that even ones with subprime mortgages received high grades from credit ratings agencies.) Investment banks Lehman Brothers and Bear Stearns, which loaded up on these securities, saw the value of their holdings plunge so much they went out of business. AIG, which insured many of these securities, also was in danger of collapse until the Fed rescued it. Under Fed chair Ben Bernanke, the Fed determined that the fall of AIG would take others down.

By intervening this way, the Fed deviated from its usual role as the banks’ banker. In the same way as consumers open accounts in a bank, banks have accounts — or reserves — with the Fed. Historically, the Fed mostly lent and supported just banks, with some rare exceptions. But in the escalating financial crisis, it engineered the rescue of AIG, intervened in the sale of Bear Stearns to JPMorgan Chase and expanded its lending to include non-banks. The Fed wanted to make credit more freely available because it was afraid that due to the big losses suffered by banks, they would freeze credit and severely limit lending, which would harm economic activity. A severe credit crunch, among other things, could lead to another Great Depression.

Once the immediate crisis was averted, and the recession ended in 2009, the Fed worked to combat persistently weak economic growth through credit-easing — popularly known as quantitative easing (QE) but with differences from Japan’s program — by injecting money into the economy through purchases of longer-term bonds and mortgage-related securities from banks and others. This 2009 program ended in October 2014. The Fed undertook this program because even with the fed funds rate near zero, it was not enough to boost economic growth.

“War wounds may heal, but scars are left behind.”–Tayyeb Shabbir

Meanwhile, the Fed began paying interest on banks’ reserves for the first time, which helps the central bank hit the target for its key federal funds rate (the overnight rate for loans banks charge each other). It’s also an incentive for banks to keep money at the Fed. “A quickening economic recovery could provide incentives for banks to withdraw funds held as excess reserves at the Fed and inject them into the real economy,” said the Federal Reserve Bank of St. Louis. “Given the significant amounts of funds held as