This week, as expected, the US Central Bank raised interest rates to 1.25 per cent and talked about normalising its policy. The statement included detailed guidance on what the Federal Reserve intends to do next.
During the financial crash and its aftermath the Fed bought up large quantities of Treasury bonds and mortgage-backed securities, forcing interest rates down and providing cash to markets as banks and investors sold their holdings. The Fed balance sheet held assets below $1trn in 2007 which now stands at $4.47trn. The Fed owns $2.46trn of government debt and $1.77trn of mortgage-backed debts.
Fed Chair Janet Yellen set out a new policy to reduce these huge portfolios by declining to reinvest in these securities each time some of them mature and pay back. She said “We anticipate reducing reserve balances and our overall balance sheet to levels appreciably below those seen in recent years but larger than before the financial crisis.” The Fed will start by running off $6bn a month of Treasuries and $4bn a month of mortgage securities. This will increase to $30bn a month and $20bn a month respectively over the following year if all goes to plan. There will be quarterly increases in the amounts involved.
The Fed also expects to put up rates more. So, we can now answer the question, what does the Fed think the new normal looks like? It thinks it means a central bank with a balance sheet maybe double the size of pre-crisis but half the size of recent months. It means an interest rate maybe double today’s, but lower than the rates we often experienced before the crisis.
The Fed stressed that it would reverse the policy of reducing the balance sheet if there were “a material deterioration in the economic outlook”. It is also a bit concerned that commercial banks will still want to deposit substantial reserves at the Fed and will need to have a policy which handles their demands. The Fed does not wish to undo all the good work done so far in repairing the commercial banks and equipping them to expand their lending intelligently to power the recovery.
It is one of those ironies that the month before the Fed finally introduced its further rate rise, inflation actually fell. The spike in inflation caused in the US and elsewhere by the rise in oil and other commodity prices last year has now run its course, with those same commodities now weaker. The Fed anticipates more general inflation and wage inflation, but so far it is all under control. The Fed is confident the US economy will pick up again, but will clearly need to watch the data carefully. If the recovery stays moderate in pace with little associated wage inflation it will be more difficult for the Fed to take rates much higher in a hurry.
It looks as if the new normal is not going to be the same as the old normal prior to the crash. It is likely to be lower interest rates and a modest pace of run down in Fed assets. The Administration has no wish for them to force up long interest rates too far when they want to see more investment, and have no wish to over strengthen the dollar when it is already dear in their view against Euro, yen and renminbi. All this is still supportive of share markets. The Fed needs to avoid being too hawkish in what so far remains a world where inflation pressures for goods and wages are subdued.
John Redwood is Charles Stanley’s chief global strategist