Returning to “Normal”

Americans traditionally look at interest rates as the guide for monetary policy and have done so for half a century. We debate over whether nominal interest rates or real (inflation-adjusted) interest rates are the primary determinants of positive or negative outcomes from our central bank’s monetary policy. Americans don’t usually consider the other, non-interest-rate elements of monetary policy-making in their historical context. We tend to be focused on US-centric history.

However, there are other forms of monetary policy, and they have been applied extensively in other places in the world. The Banque de France recently released a paper entitled “No. 17: Monetary policy without interest rates, the French experience with quantitative controls (1948 to 1973),” in which research economist Éric Monnet describes 25 years of the French experience following World War II, focusing on non-interest-rate monetary policy-making. It is a thoughtful paper with lots of citations to direct serious readers to explore the non-interest-rate aspects of monetary policy-making.  Click here to access the paper referenced. 

Monnet’s research illuminates the various forms of central bank tools that are not particularly focused on interest rates, such as capital-restraining, quantitative, and rule-making elements of monetary policy formulation.

The point of this commentary is to introduce the historical context of such elements. There are historical precedents for the use of policy tools other than the raising or lowering of the short-term interest rate by a central bank. Indeed, some of those tools are being robustly applied in various larger economies in the world today. As we recognize that there have been long stretches of European history during which European central bankers have utilized non-interest-rate policy tools, we gain insights into the application of those tools by the ECB and others in Europe.

The particular research cited above is French. We would add that studying the responses of Scandinavian countries to the Scandinavian banking crisis of the early 1990s would yield further insights. The handling of the crisis was a highly successful instance of non-interest-rate-focused policy-making. 

For our purposes, we found the research paper published by the Banque de France instructive with regard to current US monetary policy. Clearly, we now have a dual regime at work in our country. The first element of that policy regime is the attempt by the Federal Reserve to restore interest rates as a dynamic monetary policy tool. The second element is the attempt to simultaneously extract quantitative measures from Fed policy. 

Our biggest fear is that the Fed will extract the quantitative side too quickly. We worry that they be too hasty as they return to a more interest-rate-oriented stance. However, that is the stance with which the monetary policy-makers of the Federal Reserve have the greatest familiarity. If they are not too hasty in applying the tools of reverse repo, interest on excess reserves, and a federal funds rate that fluctuates between those two, they may yet successfully define a new corridor mechanism for interest-rate functions while preserving the size of the balance sheet that they carry forward from their former quantitative easing (QE) focus.

What if the Fed freezes the size of the balance sheet as it is? What if they roll the maturities and keep the duration of the balance sheet roughly in its present form? What if they opt not to vary those elements in either direction for a while but instead remain constant for a period of several years? We believe a Fed announcement to that effect would relieve pressures on the markets. Markets would not have to worry about how to absorb the balance sheet if the Fed were to state its intention not to reduce it. At the same time the Fed could assure the markets and other economic agents that they don’t intend to increase the balance sheet. 

The Fed could halt speculation about run-off provisions by saying they have no intention, at the present time, to either run balance-sheet size up or down. They could also communicate their understanding that duration matters – thus they do not intend to shock the financial markets or the economy with any major duration changes. Such a policy move would provide enormous clarity to economic agents and financial market participants. It would alleviate uncertainty and thus reduce risk premia in markets. And it would not interfere with the ability of the Fed to raise or lower policy-setting interest rates.

We offer this suggestion for consideration on the heels of this week’s FOMC meeting and the subsequent debate on Fed communication. A policy pause must be subject to changes in data, of course. All central bank policy is always subject to change. But the strategy of a freeze would allow the effects of QE on balance-sheet size and duration to be held in place for a lengthy period of time while the Fed returns policy-making to an interest-rate-centric methodology and does so at a measured pace.


David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

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