Guidance that provides clarity around both short-term interest rates and the balance sheet might help to anchor interest rate expectations—for example by indicating while purchases continue that the central bank intends to maintain overnight interest rates at low levels even after the completion of asset purchases.38 Lesson 6: Focus on one tool during normalization Uncertainty associated with managing multiple tools and the degree of substitutability between them poses possible challenges in removing policy accommodation after a zero lower bound episode, as the central bank switches from conducting policy with one lever to another. It therefore seems prudent to take a gradual approach to normalization, emphasizing one tool at a time. The Fed’s adopted normalization approach has thus far been an effective one. Starting to raise rates first, and waiting to start reducing the balance sheet until normalization in the level of overnight rates is well underway, has helped to ensure that the economic recovery is sufficiently advanced before making changes to the balance sheet.39 This strategy has reduced the likelihood that an unexpected adverse shock to the economy not long after the start of policy tightening would have necessitated a return to the zero lower bound on the federal funds rate and 7 / 13  BIS central bankers' speeches  potentially a reversal in balance sheet normalization.
First, balance sheet policies can serve as a signaling device that strengthens forward guidance and reduces expectations for the path of short-term interest rates. Putting actions behind its words—either through new asset purchases or by maintaining reinvestments—helps the central bank to establish a credible commitment to maintaining monetary easing.33 Second, balance sheet actions transmit through a portfolio balance channel, which—through the stock effect I described earlier—reduces term and risk premiums embedded in bond yields by reducing the supply of long-term bonds in the market. Many studies conclude that this channel is likely the dominant one.