New Policy Ideas, New Risks

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Special Guest Blogger: Tim Kearney

There are important developments in the running of the Federal Reserve’s monetary policy, centered on the meaning of the inflation target and the disposition of the Fed’s balance sheet expansion. Regarding the target, discussions are beginning to hone in on something akin to nominal GDP targeting or price level targeting. This is a longer-term project, as positions must be worked out and communicated.

By contrast, the discussion over the balance sheet is well underway and in fact, “normalization” seems to be happening. Although the balance sheet has increased by five times since the global financial crisis, there has been no significant inflation — the PCE deflator has averaged 1.8% during this period, the same as the 25-year average ending December 2018.

The flattened yield curve, low level of long-term interest rates, anchored inflation expectations and the fall of commodity prices imply that there is no need for the Fed to reduce the balance sheet further. Nevertheless, recent comments indicate that the reduction process will continue. Be aware that the risks for markets seem to skew more heavily to the downside.

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