“Removing accommodation is easily justified, but it is unavoidably complicated by the use of multiple policy instruments, as it was during the last normalization cycle less than a decade ago. To guide this process, the FOMC released a set of general principles for reducing the size of the Federal Reserve’s balance sheet. These principles keep the federal funds rate as the primary tool of policy adjustments with planned significant reductions in the balance sheet to begin after the policy rate had increased. The principles also reaffirm the Committee’s ample reserves operating regime and an intention to hold primarily Treasury securities in the long-run, moving away from holding mortgage-backed securities to minimize possible distortions in credit allocation.”
“These principles establish important guideposts as the Federal Reserve begins to dial back its policy settings. However, they are just a start, and a number of important and difficult decisions remain. In particular, I expect it will be important to consider the interaction between reductions in the size of the balance sheet and increases in the policy rate. What we do on the balance sheet will likely affect the path of policy rates and vice versa. For example, more aggressive action on the balance sheet could allow for a shallower path for the policy rate. Alternatively, combining a relatively steep path of rate increases with relatively modest reductions in the balance sheet could flatten the yield curve and distort incentives for private sector intermediation, especially for community banks, or risk greater economic and financial fragility by prompting reach-for-yield behavior from long-duration investors.”
