The slow and steady Fed

A rate increase in December looks increasingly likely

The Federal Reserve’s Open Market Committee said Wednesday that the not-so-rapid unwinding of its $4.5 trillion bond portfolio will finally begin in October, and markets are taking it in stride. The committee also signaled that another interest rate increase is probably coming in December, and that isn’t spooking anyone either.

There’s no reason they should since the Fed is moving at such a gradual pace that no one is being taken by surprise. “Our balance sheet will decline gradually and predictably,” Fed Chair Janet Yellen said at her news conference following the Fed meeting. We wish the pace of the asset drawdown were faster, and had begun sooner, but at least it is finally underway and will march on a steady course.

One lingering uncertainty is how far the Fed will shrink its balance sheet, which was less than $1 trillion before the 2008 financial panic. The Fed will need to keep more assets now given the increase of cash—an offsetting Fed liability—in circulation. But a return to the Fed’s pre-crisis role of buying only Treasury bonds to conduct open-market operations ought to be the goal. Former Chair Ben Bernanke sold the Fed’s quantitative easing policies as a crisis-driven necessity that would not last forever, and with the crisis now past the Fed should return to its traditional economic role for the sake of its own credibility.

No one should call any of this a tight monetary policy, not with the fed funds rate still at 1%-1.25%. The bigger question is how the Fed will respond if Congress passes tax reform that lifts growth to more than 3%. Then it may have to reconsider its slow pace of rate increases, lest it repeat its mistake of 2003 and keep rates too low for too long after a pro-growth tax cut. We know how that ended.

Source: The Wall Street Journal