Must-know: What’s the Fed’s preferred policy normalization tool?

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U.S. Federal Reserve monetary policy normalization plan

The Fed’s exceptional monetary policy stimulus involved keeping the federal funds rate at near zero levels since December 2008. The Fed also embarked on three rounds of quantitative easing (or QE). This swelled the Fed’s balance sheet to over $4.4 trillion. As the economy improves, monetary policy isn’t going to be as accommodative as before. At its October meeting, the Fed will likely announce the end to monthly asset purchases.

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The Fed’s looking to normalize monetary policy by raising the federal funds rate. It’s also looking to reduce the size of its balance sheet. It wants to bring it in line with the levels before the 2008 crisis. A large part of the Fed’s balance sheet consists of Treasuries—$2.4 trillion—and agency-backed securities. Reducing the size of its holdings would require offloading some or all of its portfolio in the market. This could lead to higher market volatility (VXX) in equity (SPY) (QQQ) and bond (IEF) (TLT) markets once normalization begins.

Part 6

Enhancing financial market stability and reducing volatility is one of the Fed’s un-mandated goals. At the end of September’s Federal Open Market Committee (or FOMC), the Fed released a statement outlining normalization principles and plans. This was done to reduce market volatility when normalization starts.

Steps to normalization—raising the federal funds rate

  • The FOMC will begin the normalization process by raising the federal funds rate when “economic conditions and outlook warrant” a less accommodative monetary policy.
  • Interest on excess reserves (or IOER) would be the primary tool for bringing the federal funds rate into the target range.
  • The FOMC expects the federal funds rate to trade below the IOER rate as long as excess reserves are plentiful.
  • The Fed may also use an overnight reverse repo (or ON RRP) facility and other supplementary tools to control the federal funds rate. However, using these tools would be temporary. They would be phased out when they’re no longer necessary. You can read more about ON RRP here.

You’ll read more about the Fed’s plans to reduce the size of its balance sheet in the next part of the series.

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