The Fed's exit from the unconventional monetary policy it has implemented since 2008, is imminent. To combat the Great Recession, the Fed lowered its policy rate to 0~0.25% range and through Large Scale Asset Purchase(LSAP), acquired substantial amount of long-term government bonds and Mortgage Backed Securities(MBS). As U.S. economy is showing signs of recovery from the deepest recession since the Great Depression, these unprecedented policy measures are expected to be normalized soon. The normalization process will begin with raising the federal funds rate that has been kept near the zero lower bound for more than 5 years. Equally important component of the exit process is the normalization of the balance sheet.
Not only the scale of the asset purchase was huge but also asset classes that the Fed bought through LSAP were not conventional. Traditionally the Fed, through the Open Market Operations, has been buying and selling short-term government bonds but LSAP bought mostly long-term government bonds and MBS. The normalization process will involve rate-raising and scaling down the balance sheet as well as returning SOMA portfolio back to the pre-crisis statue.
This paper explores the exit strategy that the Fed is planning in order to normalize the monetary policy and possible problems that it would face in implementing these strategies. It also estimates the effects of raising the federal funds rate and normalizing the balance sheet(by selling assets), using econometric tools. Without understanding of these tools and procedures in details any further analysis on the effects of U.S. monetary policy normalization on Korean economy would be superficial. In Chapter 2, we go back in time and investigate the monetary policy conducted during the Great Depression. By examining the monetary policy in the past one can draw lessons from history. From 1932 to 1936 the Fed conducted the monetary policy similar to the Quantitative Easing. But the Fed prematurely ended this as worries about inflation resurfaced. This premature withdrawal resulted in the Recession of 1937-1938. Many blame this as the main contributing factor that prolonged the Great Depression.
This is why the current authority is so hesitant and cautious about normalizing the unconventional monetary policy even as the economy is showing clear signs of recovery. In Chapter 3, we analyzed the exit tools for normalizing the monetary policy and their possible impacts. First in regards to raising the rate, interest paid on excess reserves(IOER) is likely to be used. The Fed has been paying IOER since 2008 and this tool helped keep the excess reserves that banks possess within the reserve system. With the low interest rate and the economy still in fragile state, banks did not have better and safer outside investment opportunities than keeping their cash in the Fed's vault and receiving interest income. As a result, the excess reserve increased exponentially to a level that has never been before. As the Fed is planning the exit, it is working as a big inflationary pressure. This is because as the Fed raises its policy rate, the economy's overall interest rates would increase as well and that means better outside investment opportunities for banks. If the spread between IOER and the federal funds rate widens it would be possible that substantial amount of the excess reserves are withdrawn from the reserve system and create an inflationary pressure. A solution to prevent this scenario is to raise IOER in line with the federal funds rate so that the spread between them is maintained. This, actually is what the Fed's Forward Guidance is suggesting to do.
Meanwhile, the normalization of the Fed's balance sheet is another aspect of the exit. The size of the balance sheet increased more than five-folds due to LSAP and the composition of the asset changed as well. The balance sheet normalization has two components; first reducing the size, and second, eliminating the assets - long-term government bonds and MBS - that the Fed unconventionally possesses. The Fed suggests that this process will take place very gradually. One possibility is to wait until they mature and let them roll-off from the balance sheet. Another possibility is to sell them before they mature. If the Fed chooses to wait then the balance sheet normalization process will be very slow that the size and the composition of the balance sheet won't be normalized until 2020.
The fact that unconventional monetary policy is almost unprecedented puts us in a situation where there is not enough data or theory to infer the impacts of the unwinding. But we can at least narrow our analysis down to a few seemingly important variables and focus on them. We think that some of these variables are long-term interest rate and the yield curve because the main purpose of the QE was to influence them and it is reasonable to focus our interests on these variables when unwinding of the QE takes place.
First when the Fed begins to raise the federal funds rate, it is possible that something similar to 2013 Taper Tantrum can happen where U.S. long-term rates rose substantially and created a huge instability in the global financial market. This actually is the part where most worries arise regarding the rate-increase. Meanwhile, the increase in the long-term rate can also negatively affect the domestic economy. It might depress the aggregate demand, curbing the ongoing recovery of U.S. economy.
On the other hand, something exactly opposite can happen. The long-term rate would not react to the policy rate increase and the spread between long and short rate narrows. In the extreme case the yield curve can be inverted. This is exactly what happened in 2005 when the Fed increased its policy rate. This can also create problems because it will intensify investors' risk-taking and reaching for yield behavior.
In Chapter 4, we estimated the VAR model to forecast the impacts of the rate-rise and the balance sheet normalization(asset sales). In response to the 0.5 percent point increase in the short-term interest rate, the amount of excess reserves declined. This result suggests that without the IOER, substantial amount of the excess reserves would be withdrawn from the reserve system, posing a possible threat to inflation. It also seems that, as expected, capital inflows from the rest of the world to the U.S. is inevitable. Somewhat surprisingly, the response of the long-term interest rate is minimal. According to this picture, we would have to worry about the possible effects arising from the reduced spread between long and short-term rate, namely, reaching for yield behavior and the instability in financial market cause by this. The increase in the Dow Jones Index can be interpreted to be caused by the capital inflow and the reaching for yield behavior.
The results when we applied the asset-sales shock(selling 5% of the long-term bond that the Fed currently possesses), suggest that the balance sheet normalization by asset sales would intensify the effects from the rate-rise.
The rest of the world, especially the emerging countries, is keen on knowing the impacts of the normalization. Their interests focus mainly on how much they would be affected by the capital outflow. Korea is not an exception. Taper Tantrum incidence tells us that at least within a short time span there would be substantial capital outflow from Korea. But Korea currently has significant amount of foreign reserves and well-designed macro-prudential policies. This suggests that the negative impacts that Korea would have from the normalization of U.S. monetary policy would be limited.