Simon Potter: Implementing monetary policy with the balance sheet
Keynote remarks by Mr Simon M Potter, Executive Vice President of the Markets Group of the
Federal Reserve Bank of New York, at the ECB Workshop on "Money markets, monetary policy
implementation and central bank balance sheets", Frankfurt am Main, 6 November 2017.
* * *
I would like to thank Deborah Leonard for her assistance in the preparation of these remarks,
and colleagues in the Federal Reserve System for numerous insightful comments and
suggestions.
I'd like to thank the European Central Bank (ECB), both for inviting me to give this keynote
address and for organizing this conference on money markets, monetary policy implementation,
and central bank balance sheets. I'd also like to congratulate all of the presenters and
discussants, whose engaging research and critiques help to foster a deeper understanding of
some of the many policy implementation issues central bankers face as we digest past
challenges and prepare for future ones.
This conference comes as several major central banks reached milestones using their balance
sheets as active tools for providing monetary policy accommodation. The ECB just announced it
will extend its bond purchasing program but scale back the pace of purchases starting next year.
The Bank of England completed purchases under its Gilts and Corporate Bond Purchases
schemes and confirmed an upcoming close to the drawdown period for its Term Funding
Scheme. And the Federal Reserve has begun to reduce its sizable holdings of securities, built up
through large-scale asset purchase programs (LSAPs) over the past decade.
My comments today will focus on the role that asset purchases may play in a central bank's
toolkit for implementing monetary policy. I will briefly review how the Federal Reserve
successfully adapted its operating framework to be able to achieve interest rate control with a
large balance sheet and began its gradual and predictable balance sheet normalization program.
Then, in thinking about the prospective use of asset purchases in providing additional monetary
policy accommodation at the zero lower bound in the future, I will reflect on some lessons from
the Fed's experience. Among other lessons, we have learned that asset purchases have clear
benefits at the zero lower bound, perhaps with more limited costs than initially raised; that we
had greater-than-expected capacity to conduct large purchases without harming market
functioning; and that credible communications about use of the balance sheet and expectations
for short-term interest rates support adjustments in market pricing and smooth monetary policy
transmission. As always, the views presented here are my own and do not necessarily reflect
those of the Federal Reserve Bank of New York or the Federal Reserve System.
The Federal Reserve's asset purchases and operating regime
The severity of the global financial crisis that began in 2007 challenged central banks to use both
conventional and unconventional measures to address the economic effects of the crisis and the
sluggish recovery that followed. Using its conventional tool for easing the stance of monetary
policy, the Federal Open Market Committee (FOMC or Committee) lowered its target for the
federal funds rate in a series of steps from 51⁄4 percent in mid-2007 to a range of zero to 1⁄4
percent in December 2008. With short-term interest rates effectively constrained at their lower
bound, the FOMC provided further monetary policy easing with two unconventional tools:
Forward guidance on the expected future path of overnight interest rates and asset purchase
programs aimed at putting downward pressure on longer-term interest rates, supporting
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mortgage markets, and making broader financial conditions more accommodative. Purchases
of longer-term Treasury securities, agency debt, and agency mortgage-backed securities (MBS)
expanded the size, duration, and interest rate and prepayment risk profile of the Fed's domestic
securities portfolio.
In total, from 2008 through 2014, the FOMC undertook three rounds of LSAPs, resulting in an
extraordinary expansion in the size of the Fed's balance sheet-from around $900 billion (6
3
percent of U.S. nominal GDP) before the crisis, to $4.5 trillion (23 percent of GDP) today. For all
but a brief period of that time and until last month, the FOMC maintained the face value of its
securities holdings by reinvesting principal payments received on securities held in its portfolio. I
will discuss reinvestments more specifically later.
These purchases were funded primarily by increasing the stock of reserve balances in the
banking system, which compelled changes in the operating framework the Fed uses to achieve
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interest rate control. With an abundant supply of reserve balances, variations in their supply-
the mechanism through which the Fed implemented monetary policy before the crisis-would no
longer cause meaningful changes in federal funds rates or other money market rates.
Implementation of monetary policy therefore required a new operational approach.
The Fed's current policy implementation framework uses a system of rates that it directly
administers to influence the level of short-term interest rates, without needing to actively adjust
the supply of reserves. Specifically, the Fed uses the rate of interest paid on excess reserves
(IOER) held by depository institutions as its primary tool for keeping the federal funds rate in its
target range. It supplements this tool by offering overnight reverse repos (ON RRPs) at a
specified offering rate to a broad set of counterparties, including eligible money market funds,
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government-sponsored enterprises, primary dealers, and banks. Together, IOER and ON
RRPs set a floor on rates, beneath which bank and nonbank financial institutions with access to
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these facilities should be unwilling to lend funds.
This framework has been working very well. Since December 16, 2015, when the FOMC began
the process of normalizing the stance of monetary policy, it has raised its federal funds target
range four times to a current range of 1 to 11⁄4 percent. The effective federal funds rate (EFFR)
has been within the FOMC's prevailing target range on all but one day, and changes in the federal
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funds rate continue to transmit in a predictable and effective way to other money market rates.
Balance sheet normalization commences...
With normalization of the level of the federal funds rate well underway and interest rate control
effectively established, the FOMC has now begun the process of normalizing the Fed's balance
sheet, using a program described this past June in an addendum to its Policy Normalization
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Principles and Plans. Specifically, as of last month, the FOMC is gradually reducing the Fed's
securities holdings by decreasing its reinvestment of principal payments received from those
securities, with payments being reinvested only to the extent that they exceed gradually rising
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caps.
This process for reducing the balance sheet will run in the background, while changes in the
target range for the federal funds rate are the FOMC's primary means of adjusting the stance of
monetary policy. However, the FOMC said it would be prepared to resume reinvestments if a
"material deterioration in the economic outlook were to warrant a sizable reduction in the
Committee's target for the federal funds rate," and it would be prepared to use its "full range of
tools, including altering the size and composition of its balance sheet, if future economic
conditions were to warrant a more accommodative monetary policy than can be achieved solely
by reducing the federal fund rate." These conditions help identify the types of circumstances that
might lead to some adjustments in the balance sheet normalization process, although Chair
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Yellen has noted there is a high bar for altering the balance sheet's current course.
The FOMC's balance sheet reduction strategy lays out a gradual and predictable path for
portfolio runoff, which should reduce the risk that balance sheet normalization will generate
undesirably large asset price reactions, volatility, or disruptions to financial markets or Treasury
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debt issuance. That strategy-together with the FOMC's steady communications throughout
2017 as the Committee developed it well in advance of implementing any change in policy-has
helped to keep market expectations closely aligned with the FOMC's intentions. The market
response to the commencement of the Fed's balance sheet reduction has been calm. The
removal of policy accommodation associated with the Fed's securities portfolio reductions
should over time be expected to put some upward pressure on longer-term interest
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rates. However, the relatively muted increase in term premiums seen so far may in part reflect
the non-zero probability that market participants assign to the FOMC deploying the balance sheet
again if future economic conditions were to warrant more monetary easing than could be
achieved solely through reductions in the federal funds rate, consistent with the FOMC's
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normalization plan guidance.
... but where is it headed?
The FOMC has started the process of normalizing the Fed's balance sheet and has provided
some general guideposts. The Policy Normalization Principles and Plans state that the
Committee intends for the Federal Reserve, in the longer run, to hold no more securities than
necessary to implement monetary policy "efficiently and effectively," and that it will hold primarily
Treasury securities. In the June addendum, the FOMC noted that reducing the Fed's securities
holdings will result in a declining supply of reserve balances, and that it anticipates reducing the
quantity of reserve balances to a level "appreciably below that seen in recent years but larger
than before the financial crisis."
New York Fed staff projections for possible paths of the Fed's securities portfolio-constructed
using a distribution of market participants' surveyed expectations for the future size of the Fed's
balance sheet (conditional on not moving to the zero lower bound at any point between now and
2025), along with some staff modeling to fill in details-suggest it will take at least several years
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for the balance sheet to reach its "normal" size. Uncertainty about the time of normalization
arises from numerous sources, including future levels and variability of demand for different
types of Fed liabilities, the pace at which the agency MBS portfolio will pay down, and of course
the economic outlook.
Assuming that balance sheet normalization continues uninterrupted, it seems likely that the
future balance sheet size will be driven largely by changes in longer-run demand for Fed liabilities
-in contrast to the asset-driven balance sheet of the past decade. The FOMC explains in the
June addendum that reserve balances will be driven by the banking system's demand for
reserves and the Committee's decisions about how to implement monetary policy in the future.
Banks' experiences during the crisis, structural changes in the banking system, and post-crisis
changes in financial regulations will likely increase the level and variability of the demand for
reserves relative to before the crisis, but we don't currently know the precise shape and position
of banks' demand curves. The FOMC has said that it expects to learn more about the underlying
demand for reserves during the process of balance sheet normalization. In addition, the FOMC
will need to decide what type of operating regime it wishes to run in the future-namely, whether
it believes it will be efficient and effective continuing to use a reserve-abundant operating system
(albeit with less abundance than seen at present) or returning to a reserve-scarce system, as
the Fed used before the crisis. In sizing up the balance sheet, policymakers will also need to take
into account several important non-reserve liabilities that are largely outside the immediate direct
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control of the Fed.
On the asset side of the balance sheet, the normalized size of the securities portfolio is one
whose level is consistent with the balance sheet's longer-run trend. However, even once the Fed
normalizes the size of its balance sheet and securities portfolio, the composition of its securities
portfolio will not yet be "normal." The projections I mentioned earlier-which assume ongoing
implementation of the FOMC's capped portfolio reduction strategy-estimate that the domestic
securities portfolio could contain more than $1 trillion in agency MBS at the time the balance
sheet reaches a normalized size, even though the FOMC has indicated a preference to hold
primarily Treasury securities in the longer run. Meanwhile, the maturity profile of the Treasury
portfolio at that time is projected to be more skewed towards longer-term holdings than it was
before the crisis, when the Fed held one-third of its portfolio in Treasury bills, and about
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twothirds of its holdings matured in less than three years.
A role for asset purchases at the zero lower bound
As they digest the experience of the past decade, policymakers, academics, and market
participants are engaged in an active dialogue on appropriate monetary policy strategies and the
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role of unconventional policy tools in future zero lower bound episodes. Amid widespread
concerns of a secular decline in nominal interest rates, this is not just a theoretical discourse.
The median of FOMC participants' projections for the longer-run value of the nominal federal
funds rate is currently 23⁄4 percent, leaving little room to ease the stance of policy through
changes in overnight rates. As a result, the likelihood of a return to the zero lower bound is, in
Chair Yellen's words, "uncomfortably high, even in the absence of a major financial or economic
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crisis."
Against this backdrop, Chair Yellen has expressed her views on the Fed's monetary policy
implementation tools. She suggests that whenever possible, influencing short-term interest rates
should be the Fed's primary policy lever, but that enhanced forward rate guidance and asset
purchases should be considered again if that conventional tool reaches its limit, as would be the
case if a future economic downturn drove short-term rates back to the zero lower bound. This
view is consistent with her 2016 Jackson Hole remarks, where she presented analysis making
the case that the Fed's use of forward guidance and asset purchases could improve
macroeconomic outcomes on average in zero lower bound episodes, and indicated that she
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expected these tools to remain "important components" of the Fed's policy toolkit.
The FOMC itself has not made any formal decisions about the Fed's long-run monetary policy
implementation framework. However, minutes from a November 2016 discussion about potential
choices of policy rates, operating regimes, and balance sheet policies indicate that a number of
policymakers viewed expansion of the balance sheet as an "important tool" to provide
macroeconomic stimulus in situations in which overnight interest rates were at their effective
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lower bound. This approach is consistent with the balance sheet reaction function described in
the June addendum to the FOMC's Policy Normalization Principles and Plans.
Lessons learned
Of course, whether and under what circumstances the FOMC would again activate large-scale
asset purchases are ultimately decisions for future policymakers. But, to the extent they remain a
possible tool for providing additional monetary easing when overnight interest rates fall to the
zero lower bound, it is worth considering some lessons about their use. Some personal
observations follow.
Lesson 1: LSAPs had clear benefits at the zero lower bound
Estimates of the magnitude and persistence of the effects of the Fed's purchase programs vary,
as do assessments of the relative importance of the possible channels through which such
programs are believed to work. However, research largely provides evidence that the Fed's asset
purchases put downward pressure on longer-term interest rates and eased broader financial
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conditions, helping to improve macroeconomic outcomes. Studies of asset purchase
programs conducted by other advanced economy central banks also show positive results. In his
survey of the range of research results, Joe Gagnon finds roughly similar median results for
studies focusing on programs in the United States, United Kingdom, and euro area-citing a
median effect of about a 50-basis-point reduction in 10-year yields for a purchase equal to 10
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percent of GDP.
Regarding costs, in a recent exploration of strategies for defeating the zero lower bound, former
Federal Reserve Chairman Bernanke dispels some of the common critiques of balance sheet
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programs (which he calls quantitative easing). He points to unrealized worries about an
upsurge in inflation, collapse of the dollar, currency war, and rise in household leverage, and he
questions the effects in promoting asset bubbles and inequality. He notes that fiscal risks
associated with quantitative easing must be balanced against benefits of tools that enhance
policymakers' ability to meet their policy objectives in the face of a serious economic downturn or
disinflation.
Lesson 2: The Fed could control interest rates even with a large balance sheet
An additional concern-that the Fed would not be able to control interest rates with a large
balance sheet-proved to be surmountable. As I described earlier, the Fed successfully
introduced new tools and counterparty relationships into a new operating regime that delivers
interest rate control irrespective of the level of reserve balances in the banking system. In the
event policymakers contemplate asset purchases again in the future, they should be able to
undertake them with confidence that balance sheet expansion will not compromise the Fed's
ability to effectively implement monetary policy when the time comes to lift rates from the zero
lower bound.
Lesson 3: The Fed could purchase large amounts of securities without damaging the
market
Absent a conflicting policy objective, a central bank should aim to promote good market
functioning in its operations to help ensure effective transmission to the rest of the financial
system. This objective is a vital one for the Fed because of the importance of the U.S. Treasury
market as a global benchmark. As such, the staff of the New York Fed's Open Market Trading
Desk considered how to execute asset purchase programs in ways that avoided harming market
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structures and activity. If the Fed became too dominant a buyer or holder, it could have
reduced the tradeable supply of targeted securities and discouraged trading among market
participants, leading to diminished liquidity and price discovery. A significant deterioration in
liquidity could lead investors to demand a premium for transacting in these markets, ultimately
raising borrowing costs and undermining the program's policy goal.
I do not believe the Fed's purchase programs had any unintended adverse effects on market
functioning. In fact, over time, we learned that we were able to purchase in larger sizes and
faster paces than perhaps initially expected. Secondary market purchases of Treasury securities
reached about $100 billion per month during the second LSAP program (a time when proceeds
from agency debt and MBS were being reinvested in Treasuries), and we doubled our per-issue
concentration limit from 35 percent to 70 percent. Meanwhile, monthly purchases of agency MBS
were successfully ramped up from a pace of $25 billion per month for just reinvestments in the
first half of 2012 to more than $70 billion per month later that year when additional purchases
under the third LSAP program were also conducted. This volume represented a substantial
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share of monthly gross issuance. Staff actively monitored indicators of market functioning
available in the broader market and through our own operations for signs of any material
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deterioration. As necessary, we modified our operational schedules (while still meeting the
policy directive we were given) to ensure smooth functioning, such as periods of ramping up or
winding down purchase programs.
The Fed also put in place active policies to help prevent market dysfunction as a result of its
operations. Preventive measures included concentration limits on holdings of individual Treasury
securities and prohibitions against purchasing some specific, highly-demanded securities.
Agency MBS purchases were eventually targeted at newly issued, to-be-announced (TBA)
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securities, which tend to be the most liquid and readily available. Further, we spread our
agency MBS purchases out across multiple settlement months and used dollar rolls to facilitate
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the orderly settlement of unsettled purchases. As a more general practice, the Fed actively
promotes market functioning by running a securities lending program through which primary
dealers can borrow Treasury and agency debt securities held in the Fed's portfolio.
Lesson 4: Reinvestments matter
Relatively quickly, the Fed came to learn that the reinvestment of principal payments received
from securities held in its portfolio represented a distinct balance sheet tool that could help to
maintain the FOMC's desired level of monetary policy accommodation. The FOMC initially
allowed agency debt and agency MBS acquired in the first LSAP program to run off as principal
was repaid. However, as purchases ended, a decline in mortgage rates generated increased
refinancing activity that accelerated repayments of principal on agency MBS held by the Fed. The
resultant reduction in the Fed's agency MBS holdings pushed a large supply of securities into the
hands of private investors, putting upward pressure on longer-term interest rates. In August
2010, after considering the implications for financial conditions and the economic outlook of not
reinvesting these repayments, the FOMC announced it would reinvest principal payments from
these securities in longer-term Treasury securities. Then, in September 2011, the FOMC
announced that repayments from these securities would instead be reinvested in agency MBS to
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help support conditions in mortgage markets. The FOMC then maintained reinvestments,
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including Treasury rollovers, until commencing balance sheet normalization last month.
Keeping the Fed's holdings of longer-term securities at sizable levels helped to maintain
accommodative financial conditions as economic conditions strengthened. This is because, in
addition to the acquisition of securities through asset purchases, the period over which the
central bank intends to hold its securities helps to shape market participants' expectations about
the size and duration of assets available to the public. Extending the holding period through
reinvestments prolongs this so-called stock effect. The 2010 episode when the Fed was not
reinvesting agency-related principal payments demonstrated both term premium effects that
might have been expected to be associated with a reduction in the Fed's securities holdings and
the risks associated with an unexpected increase in the publicly-held stock of agency MBS. As
we normalize the size of the balance sheet, maintaining redemption caps throughout the process
(and continuing to reinvest any principal payments received in excess of those caps) provides an
insurance mechanism that limits the amount of variation in the pace at which securities,
particularly mortgages, will flow back into private hands.
Lesson 5: Credible communications influence the effectiveness of asset purchase
programs
As a general matter, monetary policy transmits more smoothly when market participants are able
to understand and anticipate central bank actions. Managing market expectations about
monetary policy implementation takes on even more importance in the challenging environment
posed by the zero lower bound. Both in shifting into a regime that uses the balance sheet as an
active tool for policy implementation and then shifting away from such use, there is an important
interaction that the settings of overnight rates, forward guidance on those rates, and balance
sheet configurations have on overall financial conditions. Having clear and credible
communications that help market participants understand the central bank's intended use of
these tools can thus affect overall program effectiveness. Indeed, a central bank's clarity around
how it would pursue its goals at the zero lower bound can, in itself, produce a more stable
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environment with fewer and shorter trips to the zero lower bound. And even at the zero lower
bound, the speed and accuracy with which market participants understand the central bank's
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reaction function could contribute to better macroeconomic outcomes.
My analysis takes its cue from the framework proposed by Chair Yellen, where unconventional
policy tools are deployed to provide additional policy accommodation at the zero lower bound,
and a supposition that balance sheet expansion would be introduced if the zero bound is viewed
to be more restrictive than can be mitigated by forward guidance alone, just as they were during
the financial crisis and subsequent recession.
Communications are central to the two primary channels through which balance sheet policies
are believed to work. First, balance sheet policies can serve as a signaling device that
strengthens forward guidance and reduces expectations for the path of short-term interest rates.
Putting actions behind its words-either through new asset purchases or by maintaining
reinvestments-helps the central bank to establish a credible commitment to maintaining
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monetary easing. Second, balance sheet actions transmit through a portfolio balance channel,
which-through the stock effect I described earlier-reduces term and risk premiums embedded
in bond yields by reducing the supply of long-term bonds in the market. Many studies conclude
that this channel is likely the dominant one.
With this in mind, the central bank should provide clear guidance at the start of its purchase
program about its intended purchase and reinvestment plans-either in quantitative or qualitative,
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state-contingent terms-and then follow through on this commitment. It seems sensible for the
central bank to buy assets as quickly as possible, contingent on economic developments and no
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disruption to market functioning. Once purchases have been completed, the central bank
should then hold the assets for as long as it says it plans to-including maintaining its holdings
through reinvestments, as appropriate-to align realized actions with market participants'
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expectations, again contingent on economic developments.
By making purchases state-contingent-that is, tying their size or pace explicitly to the
achievement of broader macroeconomic objectives or other conditions-like the Fed did in its
third LSAP program and with reinvestments following liftoff, the central bank can help market
participants understand its balance sheet reaction function and expected changes in the public
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stock of assets. However, policymakers must also consider how market participants
understand the central bank's approach to its balance sheet in conjunction with its guidance on
the overnight policy rate. Failure to adequately distinguish between the two tools can lead to
spillovers and undesirable outcomes. A cautionary example is the 2013 "taper tantrum," when
Chairman Bernanke's announcement of an eventual cessation in asset purchases was
interpreted by market participants as signaling a sooner-than-expected increase in short-term
interest rates, prompting sharp and unexpected declines in asset prices. Guidance that provides
clarity around both short-term interest rates and the balance sheet might help to anchor interest
rate expectations-for example by indicating while purchases continue that the central bank
intends to maintain overnight interest rates at low levels even after the completion of asset
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purchases.
Lesson 6: Focus on one tool during normalization
Uncertainty associated with managing multiple tools and the degree of substitutability between
them poses possible challenges in removing policy accommodation after a zero lower bound
episode, as the central bank switches from conducting policy with one lever to another. It
therefore seems prudent to take a gradual approach to normalization, emphasizing one tool at a
time.
The Fed's adopted normalization approach has thus far been an effective one. Starting to raise
rates first, and waiting to start reducing the balance sheet until normalization in the level of
overnight rates is well underway, has helped to ensure that the economic recovery is sufficiently
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advanced before making changes to the balance sheet. This strategy has reduced the
likelihood that an unexpected adverse shock to the economy not long after the start of policy
tightening would have necessitated a return to the zero lower bound on the federal funds rate and
potentially a reversal in balance sheet normalization. Instead, the FOMC's approach promotes
the use of the federal funds rate as the active monetary policy instrument-an instrument with
which it has much greater experience, likely helping to minimize the risk of an error in the early
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and still-vulnerable stages of the economy's recovery.
Running down the balance sheet passively, in a gradual and predictable manner, once
normalization of short-term interest rates is well underway puts the balance sheet's
normalization in the background. The stock view of central bank purchase programs holds that
given an expected path of the portfolio, the pace of actual changes in the portfolio should have
little direct effect on asset prices. Assuming markets anticipate a gradual unwind in the portfolio,
asset prices would adjust gradually over time. Nevertheless, central banks may wish to mitigate
any possible risk that flow effects associated with overly fast flows of securities into private
hands interfere with monetary policy implementation or disrupt market functioning. A
conservative feature in the Fed's approach is therefore a one-year transition period during which
gradually rising redemption caps are phased in, thus allowing financial markets and the U.S.
Treasury time to adjust to the Fed's declining market presence.
These design features likely enhance overall program effectiveness. However, this outcome is
traded off against a more rapid achievement of balance sheet normalization-something some
policymakers might hold as a desirable objective. For example, they might see a smaller balance
sheet as one that offers greater capacity for using asset purchases more fully again in the future.
Such capacity may be a concern given the risk that a more normal portfolio size and composition
may not be reached before an adverse shock brings short-term rates back to their effective lower
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bound, perhaps warranting renewed balance sheet expansion. This risk may be particularly
pronounced in a low neutral rate environment. In principle, asset sales could accelerate
normalization of the size and composition of the balance sheet, but the market effects of
longduration asset sales could be uncertain, and sales could affect the path of short-term
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rates. Moreover, a central bank that does not hold the assets it has purchased as long as
market participants anticipate could lose credibility, making future asset purchases less effective.
The central bank must therefore consider the effects of its balance sheet actions in the context of
the overall monetary policy setting, including the interplay between changes in the balance sheet
and changes in interest rates. Uncertainties related to this relationship help to explain the
FOMC's choice to make changes in overnight rates its main tool for adjusting the stance of
monetary policy in the normalization process while balance sheet normalization runs in the
background. Still, having both instruments in the central bank's toolkit raises the importance of
clear and cohesive communications about their respective use.
Lesson 7: Operational flexibility is important
As I noted earlier, the Fed successfully adapted its operating regime to be able to control interest
rates even with a large balance sheet. The FOMC has not decided what kind of operating regime
it wishes to run in the long run, but one lesson from the crisis is that not all operating frameworks
may be robust to a wide range of circumstances, such as implementing policy at the zero lower
bound. If one wished to retain the option that the balance sheet could be deployed as an active
tool for policy impleme