NORMALIZING MONETARY POLICY.

• Author: Feldstein, Martin

The current focus of Federal Reserve policy is on "normalization" of monetary policy--that is, on increasing short-term interest rates and shrinking the size of the Fed's balance sheet. Short-term interest rates are exceptionally low, and the Fed's balance sheet has exploded from $800 billion in 2008 to $4.4 trillion now.

At the September 2017 meeting of the Federal Open Market Committee (FOMC), the Fed indicated its long-term goal for the federal funds rate and its near-term goal for shrinking the size of its balance sheet. In my judgment, the Fed's plan is too little, too late. I also believe the Fed's underlying goal is to increase inflation above its 2 percent target and that such a policy is wrong.

I think the Fed should have begun raising interest rates and reducing its balance sheet back in 2013 or 2014. I think the current goal of raising the federal funds rate from 1.4 percent now to 2.1 percent at the end of 2018 (when it would be a 0.1 percent real rate using the Fed's median inflation forecast) is just too slow and will continue to encourage a dangerous bidding up of asset prices.

In this article, I will begin by discussing the Fed's shift to the easy money policy. I will then turn to the adverse side effects of the quantitative easing (QE) policy, particularly the increases in asset prices that create a risk of financial instability. The next section considers the reasons that the FOMC members have continued to pursue the policy of excessively easy money. There is a brief concluding section.

The Shift to Quantitative Easing

As we all know, Ben Bernanke introduced quantitative easing as a way to stimulate economic activity at a time when the unemployment rate was very high and the recovery was very slow. Conventional monetary policy had failed to stimulate the economy even after the federal funds interest rate was cut to zero in 2008. The fiscal stimulus legislation enacted in 2009 also (ailed to raise real GDP growth because it was so badly designed.

Bernanke explained that a Fed policy of buying long-term bonds and promising to keep the federal funds rate low for a long time would cause a significant decline in long-term interest rates. That would raise the price of equities and of homes. The resulting increase in household wealth would then lead to increased consumer spending and therefore to faster GDP growth.

Bernanke explained that this would be reinforced by what he called the "asset substitution effect" in which the reduced availability of bonds in which to invest would cause households to shift their portfolios to equities.

Not everyone was convinced by Bernanke's analysis. Why would investors buy equities that were made artificially high since they would know that those share prices would eventually decline? And how important could the asset substitution effect be when the household sector's holding of Treasury bonds was less than 10 percent of its investment in equities?

Moreover, the federal government deficits were pouring substantially more bonds into the market than the Fed was buying. The Fed's balance sheet grew by less than $2.5 trillion between the beginning of the large-scale asset purchase (LSAP) program and the end of 2011 while the government debt had grown nearly twice that amount.

The skeptics were initially correct. The value of equities owned by the household sector increased by less than 20 percent between 2009 and 2011. The unemployment rate continued to increase until October 2009 when it...