The last time the Fed tried to exit emergency measures was just after the Great Depression - and it didn't end so well
The Federal Reserve has just announced a widely expected plan to begin shrinking its $4.4 trillion balance sheet, which more than quintupled in response to the Great Recession and financial crisis of 2007-2009.
The Fed held rates steady as expected but said it would begin letting maturing assets run off from its holdings starting in October.
The closest the Fed has ever come to unwinding large-scale bond holdings in such a manner was in the 1930s, during and after the Great Depression. Even then, the process was much more passive than Fed officials now envision, according to a new paper published by the National Bureau of Economic Research that offers potential insights for current policymakers.
According to the Fed's previously laid out exit plan for the balance sheet, the central bank plans to gradually start reducing the size of its asset holdings by no longer reinvesting the proceeds from maturing bonds back into its large portfolio of Treasury and mortgage bonds. The Fed acquired those assets in response to a historic credit crunch and then continued buying bonds to animate an anemic economic recovery.
"The data show that excess reserves in the 1930s were never actively unwound through a reduction in the monetary base. Nominal economic growth swelled required reserves while an exogenous reduction in monetary gold inflows due to war embargoes in Europe allowed excess reserves to naturally decline towards zero."
Excess reserves fell rapidly in early 1941 and would have unwound fully even without US entry into World War II, the authors say. "As such, policy tightening was at no point necessary and could have contributed to the 1937-1938 recession," the authors wrote.
"At no point did the unwinding of excess reserves cause an explosion of lending or inflation as critics of these QE policies fear," Jaremksi and Mathy added. Fed policymakers may even have exacerbated issues with excess reserves "by prematurely pursuing contractionary policy."
Interest rate policy was was quite a different animal back in the depression days, when the gold standard still played a dominant role in the global monetary system.
The authors are heartened by the Fed's proposed gradualist approach to shrinking the balance sheet this time around.
"Based on our findings, the Fed's policy seems historically grounded," they conclude. "The decline in excess reserves in the Great Depression occurred when the government did not try to force the money supply back to normal and instead allowed economic growth to absorb the additional money supply. The Fed's plans for an unwinding without tightening, therefore, resembles the stance taken in the 1940s, and suggests that it has learned from the premature tightening before the 1937-1938 Recession."