Fed officials finally collectively took a deep breath and announced they will begin to cut the size of their balance sheet, which has provided a liquidity safety net for the U.S. economy since the financial crisis.
The decision fully commits the Fed to a path of policy tightening, even with growth numbers remaining "eh" and Fed officials now openly puzzled about why they can't drive inflation levels higher.
The Federal Open Market Committee said today that it was leaving interest rates unchanged, but also announced that it will begin allowing assets to roll off its balance sheet next month. The Fed has been broadcasting the move for nearly a year, including outlining its methods for doing so in June, and so it was mostly expected. Nevertheless it is a momentous and historic move and represents the final step on the path to reversing the steps the bank took to stabilize the financial system in the wake of the crisis last decade.
It is also a policy activity in which Fed officials have no experience, which is perhaps why they decided to slowly escalate the amount of assets they are going to see slide off the balance sheet; this method allows the Fed to see how big of an impact the asset reductions are having, and adjust interest rate policy accordingly.
Fed Chair Janet Yellen made it clear that the Fed has no plans to tinker with this approach. Interest rates will be the active policy tool moving forward, and it will take another economic tsunami for the Fed to halt or reverse the policy, Yellen indicated during her press conference following the announcement.
To justify this move, and the expectation among policymakers for an additional rate hike this year, Yellen and other Fed officials remain dismissive of inflation numbers that have continued their decade-long shortfall from the Fed's 2% target and predict that inflation will creep toward that 2% target over the medium term.
But Yellen also admitted that policymakers' "understanding of the forces driving inflation isn't perfect," and that the Fed will continue to carefully monitor readings going forward. In fact, during the Q&A, Yellen seemed downright stumped by the inflation shortfall, labeling it a "mystery." That is about as frank as any Fed official has been throughout this period of low inflation, in which labor market improvements and steady economic growth has not translated into the sustained price gains that the Fed's economic orthodoxy would predict.
For the time being, it seems, absent an obvious explanation, it appears that low unemployment and numbers and gravity-defying asset prices are driving the Fed's desire to pull back policy.
Now the question for the Fed, then, is how it handles interest rates when half of its mandate is a black box and it is engaging in balance sheet policy experiments on the fly.