Fed Unwinding the Bernanke Experiments

Progress report

Blu Putnam, Chief Economist, and Erik Norland, Senior Economist, CME Group

Raising rates and shrinking its balance sheet, the Federal Reserve (Fed) is now part way into the process of unwinding the Bernanke emergency policies following the Great Recession. So far, the well-telegraphed approach to unwinding quantitative easing and raising rates has had no discernible impact on the pattern of real GDP, inflation or the labor markets. While Fed actions are only a part of the cause, US Treasury yields have risen and equities have become more volatile.

In this research report, we will examine the evolution of Fed policy as the Federal Open Market Committee (FOMC) seeks to create a sustainable approach to managing an economy no longer requiring emergency measures. Specifically, we will study:

  • The desired long-term size of the balance sheet;
  • Definition of a neutral monetary policy;
  • Changing the approach to setting the interest rate for required and excess reserves; and
  • Possibility of targeting the Secured Overnight Financial rate (SOFR) instead of the effective fed funds rate.

The Fed may have some interesting surprises up its sleeve for 2019. The pieces of this puzzle need to be put together in a precise order. As one contemplates the optimal size of the Fed’s balance sheet, one is led to an equally important examination of what constitutes a neutral monetary policy. Appreciating the nuances of neutral monetary policy forms the foundation of challenging the way the Fed pays interest on reserves and puts emphasis on the inadequacies of the federal funds rate as the primary policy target rate. It is going to be a very interesting debate.

I. Balance sheet shrinkage

The Fed’s balance sheet peaked at $4.516 trillion in January 2015, just above 25% of GDP. By not replacing the full amount of maturing securities, the Fed will continue to allow a steady shrinkage of its balance sheet for the next four or five years, down to around $2.5 to $3 trillion, after which the desired size of the balance sheet will be reviewed and adjusted.

There is no accepted theory relating to the optimal size of a central bank’s balance sheet. Before the financial panic of 2008, the Fed’s balance sheet was close to just 6% of GDP. By comparison, the European Central Bank (ECB) was around 12% pre-2008, and is now close to 35%. The Bank of Japan (BoJ) was closer to 25% pre-2008, and even in 2012. It was not until 2013 that the BoJ embarked on an aggressive quantitative easing program; but when it did, it went full throttle. The BoJ’s balance sheet is now almost 95% of annual GDP.

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