The Federal Reserve has increased interest rates twice this year and could do so again in December. But the economy is hardly booming along and inflation remains tame. Are the central bankers crazy? No! They simply are trying to add some monetary policy arrows to their largely empty quiver.
The near collapse of the world financial system in 2008 forced the Fed to take extraordinary action. Typically, when a recession hits, the Central Bank lowers short-term interest rates by cutting the funds rate. This encourages businesses and households to borrow, promoting economic growth.
But the Great Recession was different. After reducing rates to near zero, the economy remained stagnant. So, the Fed tried a new tool, quantitative easing. It purchased Treasuries and other securities, reducing interest rates of all types while adding liquidity to the financial system. This fostered borrowing and lending.
But after nearly 7½ years of growth, does the economy still need those crutches?
On one side are those who argue that growth is disappointing and inflation is below the Fed’s 2% target rate. Therefore, there is no reason to raise rates and risk slowing the economy.
On the other side are those who worry that we now have the third longest expansion on record. Recessions don’t die of old age, but the longer you go, the greater the chances there are that bubbles form. And when bubbles break - or the Fed has to break them - recessions follow.
The Fed is raising rates and reducing its balance sheet to build up some ammunition for the next slowdown, not to slow the economy.
The fear is if a recession hits, the Fed’s two major monetary tools – interest rates and quantitative easing – are not in a position to do much good. With the Fed funds rate currently between 1% and 1¼%, there is little room to reduce rates. As for quantitative easing, the Fed’s balance sheet is terribly bloated.
Before the financial crisis, the balance sheet was about $900 million. Today it is nearly $4.5 trillion. That is way too high for anyone’s comfort. If the Fed had to buy trillions of dollars more, it could cause significant problems for the markets.
Before the next recession hits – and one will – the Fed needs to do two things: First, it must increase interest rates to more normal levels so it has room to lower them; and second, it has to reduce its holdings of securities to a more manageable level, so if conditions demand it, the Fed can go on another buying spree.
This process of increasing rates and reducing its balance sheet is called “normalization”.
With growth moderate and inflation low, the Fed has room to normalize slowly and cautiously. Look for it to possibly raise rates again this year, and slowly continue that strategy next year. The process of gradually reducing the balance sheet is underway and could proceed for several years.
The Fed members believe that slow and steady will win the race to normalize rates and its balance sheet without creating the next recession. Because we never have been in this situation before, it is a great experiment. But it is a process that must be undertaken.