The separation principle is back – this time on the US side of the Atlantic. With today’s statement the Fed is basically embracing an ECB-style distinction between liquidity policy and monetary policy.
At the onset of the crisis some Fed officials thought there was something to the separation principle idea. Others thought it was complete nonsense.
As the crisis intensified Fed officials quickly reached a consensus that it made no sense to distinguish between monetary and liquidity policy in crisis conditions when both directly and substantially influence private borrowing rates and overall financial conditions. They thought the ECB was mistaken in sticking to this distinction.
But now the crisis is ebbing, the idea of a separation principle makes more sense to many (not all) Fed officials. I think this view is expressed in the statement today.
Among other things, it implies that the decision to wind down liquidity programmes has no direct implications for monetary policy as we are in a two-targets,-two-instruments regime (liquidity policy for market functioning and financial stability, monetary policy for output stabilisation and inflation).