PROVIDENCE, R.I. — Boston Federal Reserve Bank President Eric Rosengren Tuesday said the key to the central bank raising interest rates is not simply that the unemployment threshold has been reached, but that the fall to a 6.5% unemployment rate is also accompanied by rapid growth in the economy.
Taking questions from the audience following a speech to the Greater Providence Chamber of Commerce, Rosengren reiterated a warning made by many Fed officials in recent weeks, that these numbers are not policy targets.
In an unexpected move following its December meeting, the Fed's policymaking Federal Open Market Committee unveiled two thresholds that will guide its monetary policymaking decisions, vowing to maintain short term interest rates at historical lows until the unemployment rate falls to 6.5% or if inflation were to rise to 2.5%.
Rosengren rotates into a voting position on the FOMC this year, and he said that once the 6.5% unemployment rate is reached, however, "we are getting close enough to full employment that — depending on what else is happening in the economy at that point — we might choose to start raising short term rates at that time."
This improvement in economic conditions would have collateral benefits, Rosengren said. For instance, the nation's fiscal situation would improve if the Fed is successful in fueling more rapid growth.
Currently, he acknowledged the federal government is benefiting from low interest rates, with the debt-to-GDP ratio not growing as rapidly as it would have if interest rates were higher.
However, the Fed's focus in its balance sheet policy is on economic outcomes, not maximizing returns from its asset purchases or aiding government borrowing.
"So if the economy were to start growing rapidly, if we were to get much closer to full employment, then — regardless of what happens with the fiscal situation — we are going to be raising rates," he said.
But the Fed is not at that point now, given the high unemployment rate and quite low inflation. "So it makes sense for us to keep interest rates low," he said, repeating an argument made in his prepared remarks.
On how the Fed will manage and unwind its bloated balance sheet when the time comes, Rosengren assured that there are a variety of options available to the central bank.
And the Fed retains the ability to raise short term interest rates even with its massive holdings of securities. Rosengren listed already known options such as charging interest on reserves, which would raise rates despite the large size of the balance sheet.
At some point, however, the Fed will reduce its holdings, Rosengren said. Some of the reduction will occur naturally. For example, the mortgage-backed securities held by the Fed will decline for a variety of reasons; such as a home sales.
"So even regardless of the interest rate cycle, there is a life cycle to mortgages that means the duration of mortgages is actually much shorter than a long term Treasury bond," Rosengren added. "So ... some of our portfolio is going to shrink fairly naturally."
The Fed also now has an additional tool in the form of the pace it decides to sell its assets, which affects the slope of the yield curve.
If the central bank were to sell its securities very quickly, particularly the longer term kind, that would steepen the yield curve very quickly.
"So if you thought, for example, that the housing sector was growing too robustly — which is not a problem we currently have ... then you might want to sell your securities more quickly. If instead you want to slow down the economy more generally because the economy is growing too rapidly, or inflation is picking up, you might want to increase the short-term interest rates," Rosengren said.
So the Fed has the appropriate tools to manage its exit from the massive amounts of monetary stimulus injected into the financial system, but Rosengren warned that it must still proceed with care.
The decision to begin the exit strategy will be based on an assessment of the economy and the pace of growth, meaning mistakes could be made, he said.
"You can go too slowly and allow inflation to rise ... or you can do it to quickly and cause the economy to slow down too rapidly and then end up with a much higher unemployment rate than you are comfortable with.
"In the end it is a judgment call on what is the appropriate way to start exiting," the Boston Fed chief added, but stressed that the Fed is not yet at the point where it needs to dust off its exit blueprint, adding "I don't expect to be at that point for most of this year."
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