USA: Decoding “Normal” Interest Rates

The Fed (and every other Fed commentator) uses the word “normalization” to describe the upcoming next phase of monetary policy. While the debate focuses on when that might be — as in, exactly how long is a “considerable period?” — we’ll simply say sooner than the markets expect. Now we can answer this question recently posed to me by a financial advisor: “What does normal mean?” “Normalization” refers to the two main components of the policy response to the 2008 financial crisis: quantitative easing (QE) and zero interest rate policy (ZIRP).

By “normalization” the Fed means returning its balance sheet to its pre-crisis size by exiting quantitative easing. That was last year’s story (the “taper tantrum”), and in the September Federal Open Market Committee meeting the Fed outlined its plans for how it intends to normalize its balance sheet. Leaving aside the many “inside baseball” details, the key implication of QE was that this policy was fundamentally directed towards reducing longer maturity interest rates. The Fed supported the housing recovery by targeting the QE programs at subsidizing mortgage borrowing costs. Hence, the exit from QE debated last year led to increases mainly in longer maturity interest rates.

“Normalization” means the end of ZIRP. This second part is more “normal” in that we can compare policy rates historically over past periods of Fed policy accommodation. Importantly, when considering the degree of policy accommodation historically, we need to look at the “real” fed funds rate (the nominal fed funds rate less the rate of inflation). Today, with inflation around 2%, current policy places rates at minus 2%.

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