Asset purchases compressed the term premium, lowered longer-term yields, and provided additional accommodation at a time when further cuts in the funds rate were no longer feasible. While the cumulative effect on the term premium has been diminishing, those programs are still adding stimulus to the economy. Still, the increase in the term premium during normalization substitutes for increases in the funds rate that otherwise would have been appropriate. We interpret asset purchases and normalization as affecting the short-run neutral funds rate. Asset purchases raised the funds rate consistent with full employment and price stability. Now, normalization is lowering the funds rate that otherwise would be appropriate at full employment and price stability.
Policy Rules and the Short-run Neutral Funds Rate
A simple policy rule will help understand the effect of asset purchases, and now balance sheet normalization, on the neutral funds rate:
The longer-run r* has been declining. And the short-run r*is lower than the longer-run level, reflecting the additional stimulus warranted today to offset the persistent headwinds following the Great Recession.
Asset Purchases, the Prescribed Funds Rate, and the Substitution Effect
Before asset purchases were begun, policy rules typically prescribed a significantly negative funds rate, on the order of -6%. But further declines in the funds rate were not feasible, so the actual funds rate was stuck near zero. In this case, the prescription from the policy rule could not be realized by rates policy alone.
Asset purchases compressed the term premium, lowered longer-term rates, and provided additional monetary stimulus, compensating for—indeed, substituting for—funds rate declines that were no longer feasible. In terms of the policy rule, asset purchases raised the funds rate consistent with full employment and price stability, that is, the neutral funds rate. In principle, asset purchases, by raising r* sufficiently, could allow the policy rule’s prescription to rise to zero and, therefore, allow the policy rule’s prescription to be realized.
Balance Sheet Normalization and the Neutral Funds Rate
Now, ongoing balance sheet normalization—in effect, term premium normalization—is reversing this process. It is withdrawing accommodation for a given level of the funds rate. In that way, it is substituting for increases in the funds rate that would otherwise be appropriate to normalize monetary policy. In terms of the policy rule, normalization is reducing the neutral rate, resulting in a lower prescribed funds rate than otherwise.
Headwinds, Asset Purchases, and the Path of the Short-run Neutral Rate
The effect of asset purchases and normalization on the neutral rate can perhaps be understood in relation to the headwinds story. Yellen has argued that headwinds lowered the short-run neutral rate relative to the long-run level. As headwinds dissipate, the short-run neutral rate will converge back to its long-run level.
In a similar manner, asset purchases raised the short-run neutral rate, and as that effect diminishes—and, in principle, disappears—the short-run neutral rate would fall. In principle, if the balance sheet were fully normalized—that is, if the level of ten-year equivalents relative to GDP in the Fed’s balance sheet returned to its pre-crisis level—then the short-run neutral rate would return to its long-run neutral rate. Just as the headwinds are alleged to be persistent but not permanent—and, indeed, to dissipate over time— so is the effect of asset purchase programs on the neutral rate assumed to be only temporary. This is why we refer to the effect of both headwinds and asset purchases and normalization as affecting the short-run neutral funds rate.