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Not in Kansas Anymore: Monetary Policy Demystified

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An Alternative Universe
I remember the day after my father bought our first color television. I pretended to be sick so that I could spend the day in front of it. It wasn't until then that I realized that only a portion of The Wizard of Oz was in black and white. I sat mesmerized as I watched Dorothy open the door of her black-and-white home and step out into the Technicolor universe known as Oz and utter what has become a famous phrase, "Toto, I have a feeling we are not in Kansas anymore."

That single statement pretty much sums up where we are in terms of monetary policy today. The cyclone of late 2008 tore the very foundation of the financial sector from beneath us. The Federal Open Market Committee (FOMC) dropped the fed funds rates to effectively zero. With that action, the black-and-white world of raising and lowering short-term interest rates to apply brakes or stimulate economic activity was replaced by a somewhat surreal world of unconventional policy tools. The FOMC now tells us its consensus on where short-term rates and the economy are likely to go, and how long rates are likely to stay low. That sometimes creates more confusion than clarity given that the forecast includes outliers among participants at the meetings.

This report takes a closer look at monetary policy, what the FOMC is trying to accomplish, where voting members are in the process and ultimately, how far we have traveled from "home." Much like Dorothy, the Fed hopes to return to a familiar, black-and-white world where most policy decisions are straightforward, relying on the lever of short-term interest rates, rather than an array of options including the size and composition of the Fed's balance sheet.

We will also look at the efficacy and risks associated with current Fed strategy. The FOMC is becoming increasingly split over whether quantitative easing was more effective in stimulating the economy at the onset of the crisis, or today. There are some who fear that the size of the Fed's balance sheet has become a problem, in that it could create financial imbalances or bubbles down the road.

Read all of Themes on the Economy, including this excerpt.