Monetary policy normalization: Are we there yet?

Brendalee Scott-Novak

It now appears that the Federal Reserve will increase the Fed funds rate to 1.0 percent to 1.25 percent at the next meeting in June. The probability of this rate hike is firmly at 100 percent based on the most recent Fed forecasts.

Notwithstanding such staggering odds, and recent increases last December and early March, the projection for further hikes throughout 2017 has also breached the 90th percentile. With solid gains in employment, sharp improvements in consumer spending and forecasts for strong Gross Domestic Product growth in the next three quarters, it has become increasingly clear the U.S. economy is on a solid path to growth. So why a change in policy direction when markets are making new highs?

From the onset of the credit crisis, the Federal Reserve took aggressive action drawing upon the many lessons learned during the Great Depression. The central bank quickly sprang into action by providing loans to commercial banks and other financial institutions in an effort to contain the crisis. Lending by the Fed increased from less than $50 billion at the start of the crisis to more than $700 billion at its peak in 2009. Not only did the central bank lend aggressively, it also cut the Fed funds rate to a 0 percent to 0.25 percent historic low, essentially adopting a zero interest rate policy (ZIRP).

In addition to these conventional policy tools, the Federal Reserve charted a new course, adopting the use of two unconventional policy tools: forward guidance and quantitative easing. With forward guidance, the central bank provides direction on its future actions giving markets enough time to understand and absorb its policy implications. Forward guidance also allows for underpinning the credibility of the committee, a crucial factor for this unconventional policy tool to work effectively.

Perhaps the most widely known policy enacted by the Federal Reserve post the credit crisis was the use of quantitative easing (QE). With this policy tool, the central bank used a conventional method (via open market operations) to purchase unconventional assets (long-dated treasury securities and agency mortgage backed securities) to achieve a quasi-conventional goal (to lower long-term interest rate versus short-term rates). After three rounds of quantitative easing that saw the purchase of long-term treasuries, agency and mortgage-backed securities and long-term asset reinvestment program, the central bank’s balance sheet quintupled from approximately 900 billion to more than 4.5 trillion in assets.

Now, after an abnormally long period of utilizing conventional, unconventional and quasi conventional tools to avoid a catastrophic disruption, the central bank is seeing strong evidence to return to their core mandate of maximum employment and price stability.

The case for monetary policy normalization has found strong support among two major schools of thought: New Keynesians and Neo-Fisherian economists.

The New Keynesian supporters paint a compelling argument in using monetary policy to support stabilisation. According to the Taylor rule, the appropriate level of nominal interest rates for an economy should increase in response to rising inflation (in the context of a 2 percent inflation target) and decrease with rising unemployment (relative to the economy’s natural rate of employment).

In addition, the Phillips curve which represents the third pillar of the new Keynesian economic relationship, argues that inflation should increase as the economy approaches its natural rate of unemployment.

Deep rooted in the Monetarist theory by economist Milton Friedman, Neo-Fisherians radically advocate that high nominal interest rates are associated with high rates of inflation and vice versa. According to Fisherians, in order for central banks to increase inflation, they must employ a consistent policy of increasing short-term nominal rates. In the same way, an extended period of low inflation will be highly susceptible to deflation. Supporters of Neo-Fisherian are pointing to the mounting empirical evidence in the likes of Japan, the Euro area, Switzerland and Denmark linking those economies with low or ZIRP, with very low inflation rates.

Whether you are a supporter of the central bank’s most recent shift in policy actions, the committee is firmly on the path to pursuing policy normalization. Reducing the size of the balance sheet from $4.5 trillion, targeting a normative fed funds rate and reducing the duration and composition of assets to pre-recession levels are but a few items on the agenda. Irrespective of the tools employed or the order in which policy is normalised, a gradual and predictable approach will undoubtedly play a crucial role in avoiding any missteps.

Statistics and Data Source: Bloomberg LP., BCA Research, Federal Reserve Bank of St. Louis, Bank of Canada.

The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.

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