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The Fed Buys into Secular Stagnation



As was widely expected, the Federal Open Market Committee (FOMC) held its short-term interest rate steady on September 20 and announced that starting next month the Fed will gradually shrink its $4.5 trillion balance sheet, which it built up in response to the Great Recession to support the economy. The unexpected development was a further reduction in the median view of FOMC participants about where the short-term interest rate will settle in the long run. The Fed apparently endorses the view, promoted by research of some of its own staff, that the slowdowns in the growth rates of productivity and the working-age population have persistently lowered both the economy's potential growth rate and the rate of return on investment.

The FOMC's estimate of the so-called neutral federal funds rate had declined from 4¼ percent a few years ago to 3 percent earlier this year and is now only 2¾ percent. With the federal funds rate currently near 1¼ percent, the Fed is almost halfway through its tightening cycle (assuming that the economy does not significantly overheat in the meantime). Moreover, it is possible that the projected neutral rate will decline further, as the FOMC ponders research that suggests the long-run neutral rate might be as low as 2 percent.

The mechanics of balance sheet reduction were described in a June FOMC announcement. As its Treasury securities mature and its mortgage-backed securities are paid off, the Fed has been reinvesting all of the proceeds to keep its total assets at $4.5 trillion. Starting next month, as much as $10 billion per month will not be reinvested, so that total assets will decline by that much.1 Over time, the amount of maturing and prepaid assets that will be reinvested will decline, and the balance sheet will shrink at a faster pace. Under current plans, the balance sheet could shrink by as much as $50 billion per month by late next year. The FOMC has not indicated a long-run target for its balance sheet. Somewhere in the range of $2 trillion to $3 trillion seems most likely. The pre-recession operating procedure would imply a balance sheet of around $1.5 trillion, but most observers expect the Fed to maintain a significantly higher volume of bank reserves than under the previous regime in order to enhance the safety and liquidity of the financial system.

Shrinking the balance sheet will tighten financial conditions because it will increase the amount of long-term bonds in the market and thus push up their yields. Much of any increase is probably already priced into bond yields, given that this decision was telegraphed so clearly in advance. The 10-year Treasury yield rose only 2 basis points on September 20 (0.02 percentage points), but it has risen 58 basis points over the past 12 months, in part reflecting expectations of today's decision.

The FOMC continues to project another federal funds rate hike in December. However, Chair Janet Yellen made it clear in her press conference that many participants in the committee are troubled by the decline of measures of core inflation earlier this year. If data over the next three months do not show some evidence of inflation returning toward its target of 2 percent, as the FOMC currently expects, rate hikes are likely to be postponed.

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1. If less than $10 billion of assets mature or are paid off in a given month, then the balance sheet will decline by less than $10 billion that month.

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