Little ado about much: Fed ready to move past Great Recession

Little ado about much: Fed ready to move past Great Recession
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On Wednesday, the Federal Open Market Committee, the decision-making body at the Federal Reserve, announced the beginning of the wind-down of its massive bond-buying program.

In an anodyne paragraph at the end of the statement issued after the meeting, the FOMC announced that the Fed would no longer replace all maturing bonds in its massive $4.2 trillion portfolio of bonds. Starting in October, the Fed’s bond holdings will fall by $10 billion a month. The drawdown will gradually accelerate to a maximum rate of $50 billion a month.

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As big as $10 billion a month is, it is less than 1 percent of the whole stockpile. In her press conference after the meeting, Fed Chair Janet Yellen compared the process to “watching paint dry”— a very gradual decrease. Stock and bond markets reacted, as the Fed probably hoped, with a yawn.

 

For the moment, the lack of drama represents a big victory for the Fed. The nation’s central bank has been preparing the public for its return to monetary policy normalcy for a long time. Today’s events suggest that, for once, the message has been received.

Or, perhaps, a public preoccupied with two natural disasters and apocalyptic foreign policy speeches has other things to think about.

The Fed accumulated its vast hoard of bonds in its unorthodox, vigorous efforts to help pull the economy out of the deep pit it had fallen into in late 2008.

After the Fed brought the main interest rate it influences, the federal funds rate, pretty much to zero at the end of that year, Fed Chair Ben Bernanke and his colleagues looked for other ways to lower interest rates.

Particularly concerned with reviving the housing market, they focused on buying long-term bonds. Their reasoning was that interest rates on home mortgages, as well as on major business capital investments, move in close step with interest rates on longer-term Treasury bonds (maturity more than 10 years).

The Fed’s “large-scale asset purchases," often referred to as quantitative easing, went through three editions. Research suggests that these bond purchases lowered long-term interest rates by a whole percentage point, an enormous amount in those days of extremely low rates. Now, as the Fed reduces its bond holdings, these interest rates will rise, but most likely they will rise quite slowly.

Is the economy really back on its feet? The Fed’s diagnosis is not so much that the economy is just right, but rather that the economy needs less of a push than it has in the past. The Fed’s policy normalization aims to gradually phase out the stimulus the Fed is giving the economy.

They envision a slow decrease in bond holdings along with a step-by-step increases in the federal funds rate. Chair Yellen was clear that the pace of the normalization would be determined by incoming data, but it seems likely that the process will take 2-3 years.

Chair Yellen emphasized strong economic data. Unemployment is 4.4 percent, somewhat lower than the Fed thinks sustainable over a longer period. Incomes have risen and output is growing, although it is not growing terribly fast. The economy is chugging more than humming.

The discordant element in the economic picture is that inflation is actually below the Fed’s target. Yellen noted that such low inflation in the midst of an expansion is a bit of a mystery, but she did cite a few transient factors that should disappear quickly.

Raising interest rates when inflation is below target rubs central bankers the wrong way, but in almost every other way, the economy is doing well.

Even the massive damage caused by Hurricanes Harvey, Irma and Maria have not put a dent in the Fed’s assessment. They will cause lower output than expected during this quarter, as business are closed. The drop in oil refining output in Texas will have a particularly notable impact.

But the refineries will get back to work, most people will go back to their jobs and reconstruction activity will increase. Over the course of next year, output will get back on track. Many families will suffer major long-term harm, losing houses and jobs, but the economy as a whole will probably bounce back fairly quickly, past experience suggests.

In contrast, we have no past experience to help us forecast the results of the Fed’s policy normalization. The Fed feels confident that it has all the tools it needs to deal with unexpected developments, such as sharp increases in interest rates or higher inflation.

It actually might have more difficulty dealing with another recession, since it can only lower the federal funds rate back to zero. It could start quantitative easing again, but clearly the Fed still feels that these policies are harder to handle, less effective and more difficult to fine-tune than changing the federal funds rate.

These are uncharted waters. The lack of drama today does not guarantee a lack of drama later on. To add to the uncertainty, the FOMC now has four vacancies in its seven seats, an unprecedented situation.

A splendidly undramatic beginning to policy normalization might be seen as reason to applaud Janet Yellen and her team — even enough to give her another term as Fed chair. But we will have to wait to see whether President Trump sees it that way. The Fed’s next chapter could be very…interesting.

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.