Back to Normal: Unwinding the Federal Reserve's Balance Sheet Will Be a Challenge

The Federal Reserve finally appears ready to normalize monetary policy. Starting with the March Federal Open Market Committee meeting, the Fed is on track to do multiple interest rate hikes in 2017 and soon after should begin unwinding its balance sheet.

This path to monetary policy normalization, though, may be fraught with surprises and setbacks. Not only must the Fed avoid getting ahead of the recovery with its interest rate hikes, but it must delicately navigate the shrinking of a balance sheet that has grown fourfold since 2008.

This latter task may prove to be especially daunting since it puts the Fed in unchartered waters. Never before has the Fed had to shrink its balance sheet. It is effectively flying blind and the stakes are high. The unwinding of the Fed's balance, then, is the Fed's next big challenge.

The history of the Fed's large balance sheet begins in late 2008, when it could no longer lower its short-term interest rate target to support the recovery. The target rate reached zero percent, so the Fed began purchasing long-term treasury and mortgage-related securities in order to lower long-term interest rates. The Fed hoped it would stimulate the economy.

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