The Federal Reserve may be in the middle of an historic reduction of its $4.5 trillion (£3.4 trillion) balance sheet, but quantitative easing’s day will come again, according to the central bank’s boss, Janet Yellen.
Speaking late last night in Washington, Yellen said the federal funds rate, the key determinant of interest rates throughout the US economy, is unlikely to rise back to its previous levels of more than four per cent.
Instead, the neutral rate at which Fed monetary policy is judged to be neither expansionary or contractionary is around 2.75 per cent.
That means in future recessions the US central bank will have less room for manoeuvre with the federal funds rate, its “primary tool”, Yellen said.
Yellen said: “Our unconventional policy tools will likely be needed again should some future economic downturn drive short-term interest rates back to their effective lower bound.”
The probability of a return to a point where the Federal Reserve cannot lower interest rates any more is “uncomfortably high, even in the absence of a major financial and economic crisis”, she added.
“If the neutral rate is as low as we estimate or even lower, we will be glad to have our unconventional tools in our toolkit.”
Quantitative easing was a highly controversial policy at the start of the Western financial crisis, with critics saying it would create massive inflation or even hyperinflation. However, inflation has in fact mostly stayed well within and then below the Fed’s target range, providing a puzzle for the central bank’s monetary policymakers, the Federal Open Market Committee (FOMC) as it tries to reduce the stimulus it is providing to the economy.
Yellen insisted inflation will rise to target in the coming years. The economy is “now operating near maximum employment and inflation [is] expected to rise to the FOMC's two per cent objective over the next couple of years,” she said.
The US economy has made “great strides”, thanks to unconventional monetary policy, Yellen said.