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The Federal Reserve’s strategy after tapering

William Dudley provided an update of the Fed’s strategy for normalizing monetary policy. Under appropriate economic conditions, policy rates could begin rising in 2015, a considerable time after open-ended asset purchases have ceased. Rates increases would be tempered by tightening financial conditions and are seen to converge on a level below 4%. Discretionary balance sheet reduction should follow, not precede, rates normalization. Large excess reserves are not expected to compromise control over short-term interest rates.

The Economic Outlook and Implications for Monetary Policy”, William C. Dudley, president and chief executive officer of the Federal Reserve Bank of New York, May 20, 2014

The below paragraphs are excerpts from the speech. Cursive lines and emphasis have been added.

The post only refers to the principles of policy normalization after the reduction of open-ended asset purchases (“tapering”). The Fed’s exit principles for asset purchases are summarized here.

When and how would rates increase?

“We currently anticipate that a considerable period of time will elapse between the end of asset purchases [currently envisaged for the fall of 2014] and lift-off, but precisely how long is difficult to say given the inherent uncertainties surrounding the outlook… My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term rates.”

“With respect to the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves. My current thinking is that the pace of tightening will probably be relatively slow. This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening… if bond yields were to move sharply higher, as was the case last spring, then a more cautious approach might be warranted.”

What levels should interest rates converge on?

“In terms of the level of rates over the longer-term, I would expect them to be lower than historical averages for three reasons. First, economic headwinds seem likely to persist for several more years. While the wealth loss following the financial crisis has largely been reversed, the Great Recession has scarred households and businesses­—this is likely to lead to greater precautionary saving and less investment for a long time.”

“Second, slower growth of the labor force due to the aging of the population and moderate productivity growth imply a lower potential real GDP growth rate as compared to the 1990s and 2000s. Because the level of real equilibrium interest rates appears to be positively related to potential real GDP growth, this slower trend implies lower real equilibrium interest rates even after all the current headwinds fully dissipate.”

“Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate. Consider that, all else equal, higher capital requirements for banks imply somewhat wider intermediation margins. While higher capital requirements are essential in order to make the financial system more robust, this is likely to push down the long-term equilibrium federal funds rate somewhat.”

“Putting all these factors together, I expect that the level of the federal funds rate consistent with 2 percent PCE inflation over the long run is likely to be well below the 4¼ percent average level that has applied historically when inflation was around 2 percent. Precisely how much lower is difficult to say at this point in time… As typically applied, the Taylor Rule assumes an equilibrium real rate of interest of 2 percent. This seems much too high in the current economic environment.”

How will the Federal Reserve manage its balance sheet?

“Unlike previous normalizations of monetary policy, which only involved the level of short-term rates, this prospective tightening cycle also involves considerations with respect to the size and composition of our balance sheet. The Committee stated in its June 2011 exit principles that changes in short-term rates will be the primary means for adjusting monetary policy post-liftoff, not discretionary shifts in the balance sheet. In other words, the balance sheet will be set on automatic pilot.”

“The balance sheet would shrink post-lift-off as Treasury securities matured and mortgages were prepaid, but outright agency MBS sales are no longer contemplated during the process of monetary policy normalization.”

“I think that the language in the June 2011 exit principles with respect to reinvestment needs to be revisited. The exit principles state: ‘To begin the process of policy normalization, the Committee will likely first cease reinvesting some or all payments of principal on the securities holdings in the SOMA.’ There are two considerations that suggest to me that ending the reinvestments prior to lift-off may not be the best strategy.

  • First, such a decision might complicate our communications regarding the process of normalization. Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the Committee’s intention.
  • Second, when conditions permit, it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa.

How to manage monetary policy with excess reserves?

“With respect to the issue of how the FOMC will control money market rates with an enlarged balance sheet, the Federal Reserve already has the necessary tool—the ability to pay interest on excess reserves. However, the degree of control could be further buttressed.”

“One method the Fed has been testing is an overnight, fixed rate, reverse repo (RRP) facility. The Federal Reserve posts a fixed interest rate and accepts cash from counterparties, which include some banks, dealers, money market funds, and government sponsored enterprises, on an overnight basis in return for a security. The repo facility is “reverse” because the direction in which the funds and securities move—participants are lending funds to the Fed rather than vice versa. Users of the facility are making the economic equivalent of an overnight collateralized loan of cash to the Federal Reserve.”

“Although the testing process is still ongoing, early results suggest that the overnight RRP facility will set a floor under money market rates [whereas the interest on excess reserves may be a ceiling, see also post here]. Treasury repo rates have generally traded no more than a basis point or two below the overnight RRP rate. Thus, the early evidence suggests that this facility would help strengthen our control over money market rates.”

“The overnight RRP facility allows us to make a short-term safe asset more widely available to a broad range of financial market participants. The provision of short-term safe assets by the official sector might crowd out the private creation of runnable money-like liquid assets. This might enhance financial stability by reducing the likelihood of a financial crisis.”



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