The U.S. monetary authorities (Fed) are stepping up the contraction of their balance sheet at a surprisingly fast pace. Since peaking at $4.07 trillion last August, the Fed's monetary base has been reduced by $259.2 billion as of the latest reserve reporting date on November 26, 2014.
More than half of these Fed asset sales occurred between the end of October and the end of November. But the balance sheet remains an impressive $3.8 trillion -- a huge difference with the pre-crisis monetary base of $820-$830 billion. It is interesting to note that even at these comparatively modest amounts of high-powered money, the pre-crisis U.S. monetary policy was very expansionary: the federal funds rate was fluctuating around 3 percent while the inflation rate was accelerating above 4 percent.
Obviously, these are different times now: the U.S. financial system and the economy have changed in a rapidly evolving global context. Still, the comparison is useful because it shows how much the Fed's balance sheet will have to adjust in the months ahead.
Excess reserves keep federal funds rate down
One key aspect of that adjustment process is the Fed's statement that interest rates will remain low well after the beginning of large liquidity withdrawals to "normalize" the policy stance.
The question is: how is that possible? If the quantity of money is being reduced in as large amounts as is currently the case, would it not be normal to expect that its price (i.e., interest rate) would also have to rise?