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 excess reserves, this increased lending might lead to inflation pressures inconsistent with the Fed’s mandate of price stability.”

Shabbir observes that one “apparent paradox” in the economy is that the current rate of unemployment would typically warrant more “aggressive rate hikes than we have seen so far. However … the Great Recession and the deep changes that it has wrought in the structure of the U. S. labor market — such as the unprecedented, lengthy average duration of unemployment, relatively lower worker’s wage expectations and declining ‘union power’ — [have] cast doubts about the relative tightness of the labor market as traditionally understood in the pre-Great Recession era, which was a more close fit to the oft-mentioned ‘Phillips Curve’ relationship” — where wages rose slowly when the jobless rate was high, and vice versa.

“An important new wrinkle of the ‘natural’ rate of unemployment may be that its link with wage growth may have been transformed — if not broken — by the dynamics of this recovery from the Great Recession,” Shabbir continues. “After all, last time when the unemployment rate hovered around the current levels, wage growth was 4% vs. the present 2.3%. However, this aspect bears close attention as it is probable that the wage growth may be only delayed and not banished.”

Normalization Plan

The Fed’s normalization plan calls for raising the federal funds rate away from zero (liftoff from the zero interest rate policy or ZIRP) and reducing its $4.5 trillion balance sheet. Normalization would entail that the fed funds rate revert closer to its pre-2008 average: 4.5% from January 1990 to December 2007, according to Shabbir. Currently, the fed funds rate target is 0.75% to 1%. The Fed has raised rates three times since December 2015 — the first time since 2006 — each by a relatively cautious 0.25%. Economists expect one or two more hikes this year.

However, it is important to remember that the Fed’s normalization plan is contingent on continued growth in the economy and inflation staying near its 2% target. “It is really dependent on the strength of the U.S. economy,” says Wharton finance professor Joao Gomes. “The latest growth numbers were disappointing — we had a lot of weakness in various areas, like retail, for example. There are a lot of conditions for this ‘liftoff’” to happen. Moreover, political uncertainty and potential policy changes could dramatically alter the path of the economy.

“The big wild card is what the next Fed chair will want to do.”–Joao Gomes

Gomes does see the Fed, barring any jarring events, continuing to be “very cautious for the rest of the year into early next year.” He thinks the normalization plan released by the Fed is a “cautious” plan whose main focus is “not to derail the recovery of the U.S. economy, not to push the economy back into recession.” If the Fed raised rates too quickly, Gomes notes, it could also create problems for households that have accumulated a lot of debt in recent years as well as derail a still vulnerable housing market. “It’s probably a plan that markets are happy with as long as inflation stays around 2% or so, which for the moment there are no real expectations of anything different.”

The biggest near-term threat Gomes sees is political in nature. “The big wild card is what the next Fed chair will want to do. That’s a really important calculation because [there is a high probability that] we will have a new Fed chair … in 2018, assuming that President Trump continues to not like Janet Yellen.” This new Fed chair could favor “a more aggressive increase of interest rates and more aggressive unwinding of the balance sheet.” If that happens, he says, “unless steps are taken to reassure the markets, we will definitely see uncertainty creeping up and a lot of potential disruption to capital markets.”

Meanwhile, the European Central Bank is looking to end its own quantitative easing program as green shoots appear in EU economies. “Europe is doing much better than last year, and the year before. You see growth pretty much everywhere,” Gomes says. The jobless rate has been falling across the board, he notes, even in troubled economies such as Italy, Spain and Portugal. “Overall, the picture is very positive so I think QE is going to be done in Europe. We’ll start seeing pressure for higher interest rates next year and maybe even this year.”

Macroeconomic and Financial Markets Impact

The conventional view of the impact of monetary policy normalization is for long-term interest rates to rise “substantially. I think that view overstates the Fed’s ability to control those rates,” says Wharton finance professor Nikolai Roussanov. “Ultimately, the main drivers of those rates are the market participants’ expectations of future economic growth as well as inflation. As long as both remain subdued, I don’t think we will see as massive an increase in rates as many have anticipated.”

Gomes concurs. “The main impact on long-term rates … is expectations about U.S. growth,” he says. “There will be some impact of monetary policy normalization, but again it’s really important to remember that the goal of the Fed is not to have much of an impact. So the phasing out of the balance sheet expansion will be as slow as necessary to make sure there won’t be a big noticeable impact. [The FOMC] will largely follow the real economy and try not to have long-term rates move in any dramatic way. If they do, they will just step back. They will reduce the balance sheet … slowly.” He expects the Fed’s balance sheet to remain huge in the next five to 10 years — or longer.

“Given how gradually the Fed has proceeded so far, the fears of painful external adjustment and a repeat of the wave of emerging market crises that we saw in the 1990s are probably misplaced.”–Nikolai Roussanov

Globally, it is a different picture. The impact of the Fed’s normalization on the global markets and emerging economies could be more “profound,” Roussanov says. “During the 2013 ‘taper tantrum’ (when the Fed announced it was paring back its QE program), emerging countries and other high-yielding currencies suffered, and more outflows from those countries are likely following future Fed hikes. However, given how gradually the Fed has proceeded so far, the fears of painful external adjustment and a repeat of the wave of emerging market crises that we saw in the 1990s are probably misplaced.”

Shabbir expects to see a readjustment globally, as well as “a degree of turmoil,” including the potential for a “disruptive capital flight” from developing nations. “The currencies of the developing countries may experience elevated volatility with a weakening trend against the dollar, which may increase the dollar-denominated as well as the domestic country debt — sovereign as well as corporate — of these countries, increasing their vulnerability to economic shocks.”

For his part, Roussanov is not convinced that the low-growth narrative in the U.S. is entirely correct. “It’s true that growth has been slow, of course, but at the same time, we have seen huge advances in automation technology, spurred by artificial intelligence and machine learning, etc.,” he says. “While overall output growth has been slow, firms have been adopting new technologies, as evidenced by the rapid growth in the deployment of industrial robots, for example. Eventually, this has to manifest itself in rising productivity. The danger is that technological transformation will cause a massive disruption in the labor markets as U.S. workers are slow to acquire new skills.”

Whatever the future impact of normalization, the Fed did what it had to do. “Post-2008 crisis, Bernanke was very innovative as he devised in real time a cure on the run since no playbook existed,” Shabbir says. “Yellen’s job may be harder as she tries to unwind the policy successfully. Both the interest rate policy and the balance sheet run-up have been unprecedented. So far, the script has played [out] rather well but the curtain is yet to fall. It appears that it will end well, but such an outcome is not guaranteed.”

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