The Federal Reserve in 2015

January 23, 2015

Cathy Minehan

Looking Backwards and Forward

By Cathy E. Minehan, Dean of the Simmons School of Management

Dean Minehan retired from the Federal Reserve Bank of Boston in July 2007 after 39 years with the Federal Reserve System, having served as the President and Chief Executive of the Boston Bank and a member of the Federal Open Market Committee from July 1994 on.

At long last, it would appear that the Federal Reserve, working through its Federal Open Market Committee (FOMC), will begin the process of "normalizing" short-term interest rates sometime in 2015. This process is fraught with uncertainty, mostly because the FOMC has never faced a situation quite like this: short-term interest rates at zero and a massive Fed balance sheet primed for stimulus, in the face of a growing U.S. economy, declining unemployment and very low inflation. I want to look backwards to see how we got to this point, and then forward to some concerns about Fed policy in the coming year.

There are many reasons to believe that the Fed was an important bulwark of economic defense in 2008-9 in the wake of the economic upheaval caused by the mortgage crisis more generally and particularly the failure of Lehman Brothers in October 2008. Working rapidly and directly in the markets that had seized up after the Lehman failure, the Fed reduced short-term interest rates to zero and unleashed a series of "alphabet soup" programs (AMLF, for example, the "Asset Backed Commercial Paper Money Market Liquidity Facility") that were shaped to ease conditions in specific credit and money markets.

When those markets began to function, the Fed continued to flood the market with liquidity through efforts referred to as "quantitative easing," the results of which ballooned the assets on the Fed's balance sheet from less than $1 billion in 2008 to over $4.5 billion in 2014 (remember your Economics 101— when the Fed adds money to the economy it buys securities in the open, secondary market, thus adding securities to its balance sheet holdings).

Many argue that the Fed was at least a proximate cause of the 2008-9 crisis through a lack of bank oversight and maintenance of overly low interest rates that prompted general risk taking in the markets. However, it is undeniable that the current long, slow recovery from the crisis has received invaluable support from the FOMC's timely and innovative monetary policy. I doubt whether we would be looking at the growth that we have seen recently without those Fed actions.

That said, the FOMC now faces a unique combination of monetary and economic factors that are unprecedented both in the United States and in the developed world more broadly. It seems clear that short-term interest rates cannot stay at zero indefinitely; such rates benefit borrowers at the expense of lenders and create incentives for investors to seek higher rates of return by moving out the risk curve.

The experience of the mortgage crisis, fueled as it was by esoteric forms of securities, makes one wonder what new forms of risk taking are lurking in the markets seeking refuge from very low risk-free rates. And the massive size of the Fed's balance sheet itself has made it a large player where its usual position is to act at the margin. Since reducing a large central bank balance sheet has not been done by any other central bank like Japan or the ECB whose assets have ballooned as well, the Fed is operating in uncharted waters.

And what level of short-term interest rate is "normal" for an economy that is growing at a solid pace, with job growth in excess of 200,000 per month and strong corporate profits, but very low inflation and meager wage increases? These are factors that just don't usually occur together, either in economic history or in the models used by economists.

One can argue that the slack in the economy is greater than that suggested by the unemployment rate of 5.8%. If adjustments are made for those working less than the hours they would like, or otherwise discouraged by labor market conditions, another measure of the unemployment rate is more than double the posted rate, thus providing more room for the economy to grow without inflation. On the other hand, there are questions about whether the educated and skilled workers needed for the jobs now being created are available, leading to concerns that when wage pressures start they will rise rapidly.

The FOMC has been very clear that it takes its so-called "dual mandate" very seriously. That is, it is as concerned about growth as it is about inflation, and that slack in the labor market will put a break on its actions to increase interest rates in the face of low inflation. But how quickly things will turn, when they turn, is a source of major uncertainty.

Looking forward, the FOMC is walking a tightrope trying to thread its way between two suboptimal outcomes. On one side is the risk that it moves to raise rates too quickly and damages what some still believe is a fragile recovery. My own view is that this risk is diminishing but not zero. On the other side, is the danger of waiting too long and risking financial instability or rapidly rising inflation, or both, a risk that may be rising. This tightrope act has gone on now relatively successfully for the last couple of years, but arguably the stakes have gotten higher.

And this says nothing about the economic slowdown in both the developed and the developing world, or the bite out of corporate profits that a highly valued dollar will take. The United States seems to be poised to resume its place as the engine that drives the world economy, but that will depend in part on how the Fed does its job in 2015.