The long road to monetary policy normalisation

The monetary policy response to the covid-19 economic and health crisis was to lower interest rates, historic amounts of liquidity injected by central banks and lending to the financial sector. Policies deepened during the pandemic are about to change course amid a complex global context of a weak recovery and high inflation. This article seeks to explain the Federal Reserve's (Fed) policy during the crisis and the move towards "normalisation" of policy.

In the early 2020s, many countries had interest rates close to zero, such as the United States and the United Kingdom, and to a greater extent Germany and Japan. At the onset of the pandemic, central banks lowered interest rates even more in Western markets. Faced with falling stock markets in February and March, they stimulated the economy by injecting liquidity.

The monetary policy implemented, known as "quantitative easing", aimed to slow the stock market decline, stimulating consumption, investment and employment, which, in turn, would support economic recovery. In March 2020, the Fed announced the purchase of at least $500 billion in Treasury securities and a $200 billion increase in mortgage-backed securities (MSB) holdings to further these objectives. In June of the same year, the FED set a benchmark of $80 billion per month in Treasury securities and $40 billion in MBS purchases. The result was a $2.1 trillion increase in the Fed's balance sheet, as shown in the chart.

The financial assets purchased by the Fed become part of its balance sheets and simultaneously increase the volume of reserves of financial institutions. Banks can offer more credit so that commercial interest rates tend to fall. It stimulates consumption, investment and economic growth.

Even with these measures, economic growth remains fragile. Despite the amounts of liquidity provided by the Fed, aggregate M2 (the sum of outstanding paper money, demand deposits, short term deposits and balances in retail money market funds) in the US only increased by 6% at its peak in April 2020 and returned to normality after that. It reflects the limited impetus monetary policy has had on financial intermediation.

The sector that has benefited from the constant injections of central bank liquidity is the stock market. Many indices worldwide are at record highs, such as the three US indices (S&P 500, Dow Jones and Nasdaq), the Dax 30 in Germany or the Nikkei in Japan. Despite the slow recovery of these economies, these indices showed a turnaround in their trend and are well above their pre-pandemic level. Financial markets have been the winners during the crisis.

With negative real interest rates, the Fed announced gradual interest rate hikes and tapering in early November 2021. Policy normalisation is imminent, but its implementation remains unclear. In the minutes for December 2021, the Federal Open Market Committee (FOMC) of the Federal Reserve discussed some considerations regarding the normalisation of policy, particularly the size and composition of its balance sheets over the longer term.

There is no agreement on the means of effectively communicating the policy to financial traders: whether the federal funds rate, because of its familiarity and certainty with markets, or the reduction of their balance sheets to avoid rate hikes that might flatten the Treasury yield curve (more). On the one hand, they provide for slight increases in the federal fund's target rate, and on the other, for gradual and predictable decreases in asset holdings to improve policy effectiveness. In addition, the easing option remains to act when economic and financial conditions so require.

The normalisation of monetary policy will be a challenge for central banks. The experience gained from the 2008 crisis shows that normalisation is a medium to long term policy (as shown in the graph), and there is uncertainty as to what, how and when it will be. The European Central Bank and other central banks have remained expecting guidance from the Fed, which refused to raise interest rates and be the guardian of the currency's purchasing power, placing first the dynamics of the financial markets, as stated by OBELA. Nevertheless, the financial markets are nervous. Maintain this inflation (7%) would be terrible for them, and much higher interest rates, also. Is it the end of the bubble? Tiny economic growth with massive stock price indexes is not consistent.

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