Janet Yellen: The Challenges of Scaling Back Accommodation
First phase of retreat
US Federal Reserve Chair Janet Yellen, in her speech at the 2017 Herbert Stein Memorial Lecture, explained the challenges that faced the US Fed when it wanted to scale back its monetary accommodation from QE 1, 2, and 3 (quantitative easing). Yellen said that, by 2014, the US economy had made considerable progress toward meeting the Fed’s goals of employment and price stability. A key question the FOMC faced was how to reduce the degree of accommodation it has provided and how the economy and markets (SPY) react to such a move.
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The Fed’s test to influence long-term rates
The US Fed had two options to scale back accommodation. The first was to raise interest rates (BND) and the second was to slowly reduce the size of its massive balance sheet.
Yellen explained that the problem with rising rates was that the Fed wasn’t sure if the pass-through of rates would be effective when the Fed’s reserve balances were so high. The usual mechanism of tightening policy would be that the fed would tighten policy by removing a few reserves from the banking system. A shortage in reserves, coupled with the Fed’s signal to further tighten conditions, would lead to higher interest rates.
The problem with this approach was that the Fed had flooded the system with reserves and liquidity through its QE 1, 2, and 3 programs. A minor reduction in reserves might not have the desired impact on rates. As for the second approach to reduce the Fed’s balance sheet, there was no experience of such an exercise. Even the idea led to the taper tantrum of 2013 that disturbed the equity, bond (AGG), and currency markets (UUP) for both developed and emerging market economies.
Solution to this challenge
The solution to this dilemma was that the Fed started raising the federal funds rate, which is the rate of interest that the Fed pays on excess reserves. Banks would lend to each other at least at this rate and, by raising this rate, the fed was able to influence short-term (SHY) rates despite being loaded with reserves.
Beginning in December 2015, the US Fed has so far increased interest rates by 100 basis points (or 1%) and is set to increase the rates by another 25 basis points by the end of 2017. The US Fed has also begun its balance sheet reduction program, and we’ll discuss Yellen’s views on the balance sheet strategy in the next part of this series.