The Fed spent much of 2018 easing into a new diet, selling off assets to shrink its bloated balance sheet as part of its long-awaited policy normalization. But it might be tempted to end its long-overdue diet prematurely, particularly if the economy continues to show signs of weakening.
The stock market is experiencing its worst quarter since 2008. The S&P has fallen by double digits since October. According to a recent BIS report, central bankers across the world expect these selloffs to continue into 2019.
Sagging stock prices aren’t the only cause for concern. Earlier this month, the yield curve inverted for the first time in more than a decade. Inflation expectations and consumer confidence have also dipped in recent months.
None of this means a recession is imminent. But, for the first time in years, the Fed must contend with the prospect of a major economic downturn. Some prominent financial analysts (not to mention the president and the Wall Street Journal editorial board) have even called for the Fed to abandon its scheduled interest rate hikes. Jerome Powell’s recent reversal on raising interest rates suggests that the Fed is rethinking its approach to quantitative tightening amid growing fears about the economy.
And if these fears are warranted, we all have a cause for concern: the fact that the Fed has dragged its feet in unwinding the monetary stimulus from the last recession has significantly weakened its ability to combat another recession anytime soon.
To understand why, it’s important to understand the unprecedented actions the Fed has taken over the past decade. The Fed began dramatically expanding its balance sheet in late 2008 in response to the financial crisis. Its successive rounds of quantitative easing (QE) resulted in a fivefold increase in the Fed’s balance sheet, from roughly $800 billion in 2008 to $4.5 trillion.
More important than the change in the size of the Fed’s balance sheet during QE was the shift in the tools that the Fed relies on to implement monetary policy. In October 2008, the Fed began paying banks above-market interest rates to hold rather than lend excess reserves. As then Fed Chair Ben Bernanke acknowledged, this policy was deliberately designed to prevent the sudden onslaught of new money from spilling into the economy and causing higher inflation.
Unfortunately, this policy had the effect of discouraging bank lending in the economy and exacerbating the credit crunch at precisely the time when more liquidity and bank lending was needed. With the Fed paying above-market interest rates on excess reserves, banks had little incentive to make loans. Excess reserves piled up as credit markets ran dry.
Traditionally, the Fed has relied on a “corridor” system, using open market operations to adjust the federal funds rate (FFR) to its desired level somewhere between zero and the discount rate. In 2008, the Fed began paying banks interest on excess reserves (IOER). Since then, the IOER has effectively replaced the FFR as the chief instrument of monetary policy. Since the IOER in theory serves as the floor in the fed funds market, economists refer to this new operating system as a “floor” system.
How does the change affect the Fed’s ability to combat the next recession?
Under its traditional operating framework, the Fed would respond to a crisis by buying securities to inject more reserves into the banking system, thereby lowering the FFR. But the Fed has already saturated the market with liquidity. And despite the Fed’s stated desire to “normalize” policy, it is still paying banks to hold excess reserves. Indeed, banks today sit on more than $1.6 trillion in excess reserves. The IOER is currently 2.20 percent, the same as the effective FFR.
By moving to a floor system, the Fed effectively neutered what has historically been its most effective policy tool: open market operations. Pouring in more reserves is unlikely to provide much of a stimulus when banks are already awash in excess reserves.
Can the Fed respond to a severe economic downturn under a floor system? Perhaps. In theory, it could reduce the IOER to encourage banks to make more loans and hold fewer excess reserves. Unfortunately, as George Selgin has noted, it would likely take a dramatic reduction in the IOER to make banks reduce their excess reserves. This would become even less likely if the financial system itself was at the epicenter of the next crisis, as troubled banks would again be content to hoard excess reserves rather than risk lending into a weak economy. But we are in uncharted waters. That means policy makers are more likely than usual to make mistakes.
All things considered, the Fed isn’t in fighting shape. It should have been trimming its balance sheet and normalizing policy over the past decade. Instead, it clung to its clumsy floor system and bloated balance sheet. With so much economic uncertainty on the horizon, we can only hope it is not too late for it to get in shape.