The Federal Reserve, on Avalanche Patrol

In September of last year the Fed laid out in rough terms which tools it intends to use in the normalization process and the order in which it plans to use them. Of course, as has been its hallmark post-crisis and as evidenced in its most recent Minutes, the Fed has indicated it’s ready to adjust its plans as and if needed.

Nonetheless, there has been a fair amount of discussion around the Fed’s preference to begin the normalization sequence with hikes in the policy rate, as opposed to letting its balance sheet start to run off first. This post aims to lay out in simple terms why the Fed is approaching normalization in this fashion.

You have to start with where the Fed sees the risks.

The Fed is not worried about the economy overheating. True, there is a legitimate debate over the degree of slack remaining in an improving labor market. But demography, technology and globalization, in some admixture, have conspired to cloud this picture.  In fact, it has made the issue so hard to call that the Fed has effectively let the other half of its mandate, inflation, cast the deciding vote. And so far inflation continues to come out on the side of slack.

The Fed is not worried about the balance sheet or excess reserves, either. These are means to an end, not ends in and of themselves. Moreover, the risks to an enlarged balance sheet have been over-imagined at every stage of the post-crisis period, whereas the damage that higher long term rates could do to a recovery that never quite gets to liftoff is arguably very real. Again, there is simply not enough optimism in the US economy or global economy for overheating to be the preponderant risk.

What the Fed has begun to worry about is financial stability—even if not as an imminent threat. Its concerns are one part risk management, one part the ghost of crises past. FOMC members understand that financial excesses are a positive function of time. Stability sooner or later breeds instability. And the longer rates stay very low, the greater the risk they become built into the current financial architecture and baked into our extrapolations. Once you get to such a point, an eventual normalization becomes a lot riskier, in terms of both financial dislocations and economic activity.

Also, perhaps even more than the rest of us, the Fed fears a repeat of the 2013 Taper Tantrum—not to mention 1994. For this reason, it is useful to think of the Fed’s mindset here as being like that of the avalanche patrol at a ski resort. You detonate your tools in order to see if there are any avalanches out there to be triggered. You don’t know if there are any out there, but you know the longer you wait, the larger the risks grow in probability and magnitude. In essence, it’s just good risk management.

In short, if the risk is overheating, you want to influence the cost of economic borrowing. If the risk is financial stability, you want to affect the cost of leverage. In this case, the policy rate is the place to start because it controls the cost of leverage, whereas encouraging a steep yield curve by first letting the book run off adversely hits the cost of borrowing.

This is not to suggest policy rates should be the primary tool with which to manage financial stability risk. Adequate capitalization and a robust and flexible regulatory framework have to be the first lines of defense. And, it’s also true that risk appetite can at times be stubbornly insensitive to the price of money—as we saw in the 2005-07 period and as we have seen on the other end of the spectrum over the last handful of years. However, the policy rate can be used to signal, to keep us on our toes, and to help clear the slopes now so as to lower the risk of triggering a larger and potentially destabilizing avalanche later.