Two years ago, top officials at the Federal Reserve mapped out a strategy for withdrawing the central bank’s unprecedented support for the American economy.
The official communiqué was titled “Policy Normalization Principles and Plans,” and it was supposed to serve as a rough outline for the tenure of newly installed Fed Chair Janet L. Yellen. Essentially, it consisted of two basic parts: Raise interest rates, and shrink the central bank’s massive balance sheet.
But now, both of those steps are being called into question as Fed officials grapple with an economy that appears to be stuck in first gear. Instead of executing its exit strategy, the Fed is confronting the possibility that the dramatic measures it took to safeguard the recovery will remain in place indefinitely.
"Maybe this is one of those cases where you can’t go home again,” former Fed chairman Ben S. Bernanke wrote in a recent blog post arguing for a shift in course.
The central bank has made no official changes to its strategy, which was adopted with a nearly unanimous vote. But just getting started clearly has been a challenge. The Fed has struggled to increase its benchmark interest rate this year after raising it above zero in December for the first time since the Great Recession.
That move was supposed to be the start of a gradual process of normalization, in which the Fed slowly turned up the dial on its target interest rate until it reached about 3.5 percent, close to its historical average. Several times this year, officials suggested that they were preparing to hike, only to punt amid financial market turmoil and fractures in the global economy. The Fed’s top brass met Tuesday in Washington and will release its statement on interest rates Wednesday afternoon, with a news conference with Fed Chair Janet Yellen to follow. But investors largely expect them to keep rates steady until December, or even later.
Even once rates do rise again, there is growing acceptance within the central bank that they are unlikely to increase as much as initially anticipated. Officials now estimate rates will only likely reach about 3 percent. Investors believe even that could be too optimistic.
Indeed, some economists fear the next U.S. recession may not be far off — and that means the Fed should be not be considering withdrawing its support but debating what more it could do. "Fed is almost certain to make a mistake," tweeted Narayana Kocherlakota, a professor at the University of Rochester in New York and former head of the Minneapolis Fed.
Other countries have already been forced to wade more deeply into uncharted policies. Europe and Japan introduced negative interest rates, in which institutions are paid to borrow money. Helicopter money, in which a central bank directly finances government spending, doesn't seem like a remote possibility.
“We’ve been out on the precipice for a while,” said Brad MacMillan, chief investment officer at Commonwealth Financial Network. “Whenever you get to a real transition point, that’s when the uncertainty is maximized.”
The intense focus on when — and if — the Fed might raise rates again has overshadowed the second step in the central bank’s exit strategy: shrinking its $4.5 trillion balance sheet. Under the published plan, the Fed would reduce its holdings of long-term Treasurys and mortgage-backed securities by not replacing them when they mature.
The process is not supposed to begin until well after rate hikes are underway, and the Fed has explicitly stated it does not intend to sell any of its assets. Over time, officials generally expected that the Fed’s balance sheet would remain larger than it was before the financial crisis, but smaller than it is now.
“The Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively,” the communiqué reads.
But that principle is now being second-guessed as well. At the Fed’s exclusive annual conference in Jackson Hole, Wyo., which draws some of the world’s most influential policymakers, several prominent economists argued that the Fed should maintain a large balance sheet indefinitely. The idea has the backing of Bernanke, who recently questioned Yellen’s continuing support for the exit strategy outlined two years ago.
“Does this plan make sense? The answer is not clear cut,” wrote Bernanke, who is now a distinguished fellow at the Brookings Institution. The Fed’s “plan to return to a pre-2008 balance sheet and the associated operating framework needs more thought.”
The central bank has been careful to leave itself plenty of room to adjust its strategy. The Fed has emphasized that its policy decisions will depend on the evolution of the economy. The last sentence of its exit plan warns that the entire document is subject to change.
“The Committee is prepared to adjust the details of its approach to policy normalization in light of economic and financial developments,” the statement reads.
Indeed, the Fed has repeatedly pushed back plans to reduce its stimulus in the years since the 2008 financial crisis. The first version of its exit strategy was released in summer 2011 and called for the Fed to start shrinking its balance sheet before raising interest rates. Just over a year later, the central bank was moving in the opposite direction, pumping money into the economy and strengthening its commitment to not raising interest rates.
Such shifts have threatened to undermine the central bank’s credibility, particularly when paired with frustratingly weak economic growth. Both inside and outside the institution, economists and academics are debating whether the Fed needs an entirely new approach.
“Nothing succeeds like success,” said Joseph Gagnon, senior fellow at the Peterson institute for International Economics and a former Fed economist. “If you actually do it enough, you will validate beliefs in your policy. … If you don’t, you actually raise questions.”