economic commentary

WEEKLY ECONOMIC COMMENTARY IN THIS ISSUE: Global Economic Research • Toward A More Conventional Fed 50 South La Salle Street • Rates Are High, But Credit Is Easy Chicago, Illinois 60603 northerntrust.com • A Major El Niño Takes Shape Carl R. Tannenbaum I haven’t always taken the most conventional approach to economics. In a world where Chief Economist many practitioners construct elaborate models to arrive at conclusions, I often find more value in simply following my instincts. During stressful times and paradigm changes, thinking outside of the equations is essential. Ryan James Boyle Chief U.S. Economist There are times, however, when conventional approaches are the best ones. After almost two decades of unconventional policy, the Federal Reserve seems intent on turning back the clock. Vaibhav Tandon Chief International Economist During his recent speech to the Federal Reserve’s conference at Jackson Hole, Chairman Kevin Warsh asserted that “short-term interest rates are the predominant tool to achieve the [Fed’s] dual mandate. Unconventional policies to spur economic activity may suit genuine crises but should otherwise be used sparingly, if at all.”

This statement was a succinct critique of monetary policy since 2008. As the global financial crisis took hold, central banks reduced interest rates to very low (or, in some cases, negative) levels. It was clear, however, that those actions alone were not going to reverse the contraction of credit that threatened to produce a second Great Depression. Central Bank Assets Federal Reserve Balance Sheet As a Percent of GDP Japan Eurozone U.K. U.S. $10.0 140%

Trillions $6.0 80% $5.0 60% $4.0

$0.0 0% Sources: Federal Reserve, Haver Analytics

Drawing on his study of the Depression, then-Fed Chair Ben Bernanke initiated a series of novel strategies. The central bank began quantitative easing, purchasing government bonds to bring down long-term interest rates and encourage investors stay in the markets. Other central banks followed suit, going to much greater lengths in their quests to restore financial stability.

Slowly but steadily, conditions improved. Debate continues over which components of the program were most effective, but that may miss the point. The Fed’s commitment to pursue a range of remedies over a long period of time steered sentiment in a manner that was conducive to recovery.

When the worst of the crisis had passed, there were questions as to whether unconventional policy should be unwound. The Fed chose to press on, expanding its balance sheet well into the following decade. Warsh, a member of the Board of Governors at the time, pushed back. In 2010, he expressed: “I am concerned that we are assuming too much efficacy from further securities purchases and too little risk from the expansion of our balance sheet.” The new Fed leader wants to limit the use The Federal Reserve essentially prints money to pay for the securities it holds on its balance sheet. of unconventional This adds reserves to the financial system, easing credit. While the links between reserves, the tools. money supply and inflation are not as clear as they were forty years ago, it is still fair to say that more reserves can tend to put upward pressure on the price level.

The Fed finally began reducing its balance sheet in 2018, but paused the effort the following year when financial conditions tightened. After expanding its asset purchases during the pandemic, the Fed initiated a second round of “quantitative tightening” in 2022. At present, the Fed’s total assets are about $2 trillion lower than their peak. The process hasn’t been entirely smooth; market liquidity has become thin at times during the last four years, leading to questions about how low the Fed’s balance sheet can go.

There has been a lot of research devoted to the neutral level of interest rates, which has informed the Fed’s thinking about whether policy is tight or easy. But there has been relatively little done to determine what an equilibrium level is for the Fed’s balance sheet. That answer depends, in part, on the Fed’s liabilities. These consist primarily of currency in circulation, reserves held by banks with the Fed, and the…