What are the main steps of the Federal Reserve's monetary policy normalization process?

Okay, that's a great question. Let's skip the complex financial jargon and I'll explain it to you in plain language, so you're sure to understand.

You can imagine the economy as a person. Sometimes it gets sick, like during the 2008 financial crisis or the 2020 pandemic. At these times, the economy 'catches a fever' and becomes very weak. The Federal Reserve (Fed) acts like a doctor, needing to administer strong medicine to help the economy recover. This 'strong medicine' refers to 'unconventional' monetary policies, primarily two strategies:

Zero/Ultra-low Interest Rates: Reducing the cost of borrowing to almost zero, encouraging people to borrow for investment and consumption.
Quantitative Easing (QE): The Fed directly 'prints money' to buy assets like government bonds in the market, injecting a large amount of money into the system, much like giving a patient an IV drip.

Alright, now the economy is slowly recovering, perhaps even overheating (e.g., high inflation). The doctor then has to consider stopping this strong medicine to let the patient return to normal life. This 'stopping the medication' process is called monetary policy normalization.

It mainly involves three steps, like a combination punch:

Step One: Tapering (Reducing Asset Purchases) – Turning Down the 'Faucet'

This is the first step of normalization, and it acts as a signal.

What does it mean? During the previous period of Quantitative Easing (QE), the Fed was buying tens or even hundreds of billions of dollars worth of bonds in the market every month, essentially keeping a large faucet open and letting water flow. Tapering means the Fed decides: "I'll buy $80 billion this month, $60 billion next month, then $40 billion the month after..." gradually reducing the amount of purchases until it stops buying entirely.
You can think of it this way: The doctor sees the patient improving and decides to slow down the IV drip, eventually removing the needle. This process is Tapering. It signals to the market: "Hey everyone! The days of easy money are coming to an end, get ready, I'm starting to tighten policy!"

Step Two: Raising Interest Rates – Hitting the 'Brakes'

This is the most crucial and direct step, what you often hear about in the news as "the Fed raising interest rates."

Which interest rate is being raised? It's the "federal funds rate," which is the interest rate banks charge each other for overnight borrowing. You don't need to worry about the specifics, just know that it's a "benchmark interest rate," and when it changes, other interest rates follow suit.
How does it affect us? When this benchmark rate goes up, the cost for banks to borrow money increases. Banks then pass this cost on to ordinary people and companies. As a result, your mortgage rates, car loan rates, and credit card interest will all become higher, and the cost for companies to borrow for expansion also rises.
What's the effect? With borrowing becoming more expensive, people are naturally less willing to take out loans for consumption or investment, and the amount of 'hot money' in the market decreases. This is like gently applying the brakes to a car going too fast (an overheating economy) to slow it down and control inflation.

Step Three: Quantitative Tightening (QT) – 'Draining Water' from the Pool

This is a further step after interest rate hikes, also known as "balance sheet reduction."

What does it mean? During QE, didn't the Fed buy a whole lot of government bonds? These bonds are held on the Fed's "books" (balance sheet), which made its balance sheet size very large. QT is the reverse operation.
How does it work? It mainly involves letting the bonds it holds mature naturally. Upon maturity, the principal is repaid, and this money is then not reinvested into the market. For example, if a $100 bond matures, the Fed receives $100 back, and that $100 then effectively disappears from the market. This is equivalent to directly draining money from the market's 'money pool'.
You can think of it this way: If QE was 'filling the pool' with water, then QT is pulling the plug on the pool, letting the water gradually drain away. This truly reduces the amount of money in the market, having a stronger effect on cooling down the economy.

To Summarize

So, the Federal Reserve's roadmap for monetary policy normalization is very clear:

Signal → Brakes → Drain

Tapering (Turning off the faucet): Stopping the flow of money, issuing a warning.
Raising Interest Rates (Applying the brakes): Increasing borrowing costs, slowing down the economy.
QT (Draining water): Directly withdrawing funds from the market, further tightening policy.

The entire process aims to control excessive inflation without pushing the economy into a recession, allowing the 'economy car' to run smoothly and healthily. I hope this explanation helps you!