The Fed is still on track to gradually tighten its monetary policy by using two related instruments, raising interest rates and gradually reducing its securities holdings.
What follows inititally is a bit of familiar history.
In response to the severe economic downturn and the financial crisis that gripped the U.S. in 2008 and 2009, the Federal Reserve took a series of unprecedented measures to boost the economy out of the Great Recession.
Aside from bringing interest rates down to essentially zero, the Fed injected massive amounts of liquidity into the economy by dramatically expanding its balance sheet four-fold to a peak level of about $4.5 trillion in 2014.
There is little doubt that over the past decade of quantitative easing (QE), the American economy has been strongly supported by this massive injection of monetary easing.
The central bank knew that its unprecedented monetary expansion would eventually be reversed, and in September 2014 announced a plan for moving towards monetary normalization and ending quantitative easing (QE).
The FOMC indicated that there would be two main ingredients in its policy normalization: gradually raising its target range for the federal funds rate to more normal levels and gradually reducing the Fed’s securities holdings.
Under the direction of Janet Yellen, QE formally ended in 2014 and began shifting to a post-crisis monetary policy by gradually raising the federal funds rate, with three 25 basis point rate hikes in the last 12 months and more expected later this year.
Unwinding the balance sheet occurs via allowing increasing amounts of mortgage and Treasury debt to mature without being reinvested. The normalization plan is to shrink the balance sheet to about $2.5 trillion to $3 trillion over the next few years, depending on future market conditions.
Nonetheless, some observers worry that the Fed may over do it on the tightening side, particularly because of America’s huge budget deficit and the flood of Treasury bonds into the private sector.
The concern is that without the additional buying by the Fed there will be a negative impact on the bond market. To date, however, the bond market concerns seem rather unwarranted as the market place has easily digested the increase in the government’s deficit financing.
Some critics still believe that the Fed may be forced to halt its balance sheet tapering process before year-end due to America’s widening fiscal deficit, if the surging Treasury-bill issuance puts upward pressure on the effective fed funds rate at a time that policy makers want to keep rates steady.
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The Flattening Of The Yield Curve Still Spooks Financial Markets
Although the American economy’s growth and inflation rates have been moving in line with Fed expectations, the overall operating economic and financial environment seems more uncertain.
What really preoccupies the financial markets is the relatively flat yield curve, which has a differential between 2- and 10-year governments of only 30 basis points, a level that in the past has signaled a significant economic slowdown.
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