Fed Turns Back to Conventional Policy After Unconventional Era

Chief Economist for Northern Trust Carl Tannenbaum argues that after almost two decades of unconventional monetary policy, the Federal Reserve is returning to more conventional approaches. During his speech at Jackson Hole, Chairman Kevin Warsh stated that short-term interest rates are the primary tool to achieve the Fed's dual mandate.

Since the 2008 global financial crisis, central banks reduced interest rates to very low or even negative levels. However, these actions alone were not enough to reverse the contraction of credit and prevent a potential second Great Depression.

The Federal Reserve then introduced novel strategies under Chair Ben Bernanke's leadership, including quantitative easing. This policy involved purchasing government bonds to lower long-term interest rates and encourage investors to stay in the markets.

While there is debate over which components of the program were most effective, Tannenbaum suggests that the Fed's commitment to a range of remedies over an extended period helped steer sentiment towards recovery. However, some experts question whether these unconventional policies should be unwound and if their expansion has led to unintended consequences.

The Federal Reserve is now focusing on reducing its balance sheet by about $2 trillion from its peak. To achieve this, the Fed will likely reduce bank reserves rather than currency in circulation or other liabilities. Tannenbaum suggests that updating bank liquidity guidelines, increasing access to the discount window, and introducing a tiering system for interest rates could incentivize banks to purchase market-based liquid assets.

The Fed's balance sheet reduction is expected to be cautious, with some $1 trillion in securities maturing within the next year. Tannenbaum concludes that a return to basic principles may be wise, even if it means abandoning some of the unconventional policies implemented since 2008.