Plosser: Begin Tapering Bond Buys; End by Dec. 31

HONG KONG — Downplaying the weak March employment report, Philadelphia Federal Reserve Bank President Charles Plosser said Thursday there have been sufficient improvements in the labor market to begin scaling back Fed bond buying straightaway and said the Fed's third round of large-scale asset purchases should be wrapped up by year's end.

As the Fed ends asset purchases and moves in the direction of eventual Fed rate hikes, Plosser also urged that the Fed widen the spread between the federal funds rate and discount rate. And he said the Fed should reinvest proceeds of maturing securities in short-term, rather than long-term assets.

Plosser, addressing a seminar at the Hong Kong Bankers Club, said that when the time comes for the Fed to begin tightening monetary policy, the "exit strategy" principles enunciated by the Fed's policymaking Federal Open Market Committee in June 2011 should still apply. But he said the Fed will likely need to sell assets even faster than thought then because of the further expansion of the Fed's balance sheet.

He said the Fed should move to a "corridor" interest rate system, focusing on targeting the federal funds rate between a lower rate on excess reserves (IOER) and a higher discount rate. To ensure that the funds rate trade above the IOER, he said the Fed will likely require "a significant reduction" in the amount of reserves in the banking system.

Last Friday, the Labor Department reported that non-farm payrolls rose by 88,000 in March -- less than half what had been expected. The unemployment rate dropped a tenth to 7.6%, but this was attributed to a nearly half-trillion decline in labor force participation.

The report was widely interpreted as delaying reductions in the amount of new money the Fed is pumping into the financial system. But Plosser cautioned against drawing too many policy implications from the jobs data in remarks prepared for delivery in Hong Kong.

"In my view, a case can be made that we have seen sufficient improvement to begin tapering our asset purchase program with the objective of bringing it to an end before year-end," he said.

Plosser, who is not a voting member of the FOMC but serves on an FOMC subcommittee on communications, noted that, since last October, private nonfarm payrolls have increased on average by 202,000 per month and that the unemployment rate has averaged 7.8%, compared to its 10% peak. He also pointed to a decline in the average duration of unemployment and the share of long-term unemployment, and he noted that hours worked and earnings have risen.

"While further progress would certainly be desirable, I believe the evidence is consistent with a significantly improving labor market," he said. "It is appropriate to begin scaling back the pace of asset purchases."

Plosser emphasized that "ending asset purchases is not the start of an exit strategy, nor would it indicate that an increase in the policy rate was imminent." Rather, "it is a way to halt efforts to continuously expand the level of accommodation by increasing the size of the balance sheet."

"Given the improving economy, dialing back asset purchases is an appropriate response," he said.

The former University of Rochester economics professor and Shadow Open Market Committee member acknowledged market "disappointment" with the jobs data, but observed that "monthly employment numbers are highly volatile and fluctuate a great deal from month to month."

"Indeed, while the March reading was lower than expected, the February payroll increase was higher than expected, at 254,000," Plosser continued. "Such swings are not unusual. Moreover, the first release is only preliminary and is subject to revision, and recently the revisions have tended to be upward."

"We must be cautious as policymakers not to overweight the short-term numbers, especially when they are often subject to substantial revision," he went on. "Excessive focus on the short term is often a recipe for long-term problems."

Plosser recommended that, before the FOMC actually begins raising rates, it take two other steps in addition to "gradually eliminating" asset purchases.

First, he said, "we should seek to normalize the spread between the Fed's discount rate on overnight loans to financial institutions and the funds rate target."

Before the financial crisis hit in 2007, the primary credit rate at the discount window was set at 100 basis points above the federal funds rate. During the crisis, the Fed reduced the spread to 25 basis points. It widened it to 50 basis points in February 2010, where it has stayed ever since.

Now, Plosser said, "there is little reason to maintain this crisis-initiated policy, and so we could begin to restore the spread to more normal, or non-crisis, levels."

Second, he said the FOMC should "rethink our reinvestment strategy." At its March 20 meeting, to prevent any "passive" shrinkage of the balance sheet and to keep downward pressure on rates, the FOMC reaffirmed a policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.

But Plosser said the reinvestments should be reoriented toward the short end of the yield curve.

"There are no longer any short-term Treasuries in the Fed's portfolio," he said. "Rather than reinvesting maturing and prepaid assets into longer-term assets, it might be prudent to reinvest into shorter-term assets. That would provide more flexibility in managing our balance sheet as we move forward."

Once the Fed moves beyond lessening the amount of stimulus it is providing to actually tightening monetary policy, Plosser suggested the FOMC will need to reduce the balance sheet much more actively.

Fed Chairman Ben Bernanke and others have mused about holding onto securities longer and allowing them to run off as a way of reducing the balance sheet more slowly than envisioned in the FOMC's June 2011 exit strategy. That alternative approach is under strong consideration.

But Plosser indicated he doesn't think it is advisable.

"In my view, the exit principles adopted by the Committee two years ago still apply," he said. "In particular, we should seek to return to operating in a corridor system, where the fed funds rate is the primary policy instrument."

"The balance sheet should shrink in size to enable such a system to operate," he continued. "And the composition of the Fed's balance sheet should return to all Treasuries. But the specific timing and sequence of the steps detailed in the exit strategy may require some adjustments in light of the larger, and still growing, size of our balance sheet."

Plosser said that if asset purchases continue at the current $85 billion per month pace, reserve balances could grow to $2.25 trillion or more." And he said "that may require the Fed to sell assets at a somewhat faster pace than contemplated in the principles adopted in 2011."

He said "this action would heighten the risk that the Fed would be selling longer-term assets at a loss, which would affect the Fed's remittances to the Treasury. There might even be negative remittances."

While eliminating remittances "would not impair the Fed's ability to implement monetary policy or have any direct macroeconomic consequences," but said "the situation will be noticed, especially at a time when the federal government and the public are keenly focused on the need to reduce deficits."

"This would also come at a time when the Fed is paying higher interest to banks on their reserve balances at the Fed," he noted.

In Plosser's "preferred policy framework," which other Fed officials have also spoken kindly of, "the federal funds rate target would be set in a corridor bounded below by the interest rate paid on reserves ... and bounded above by the primary credit rate."

Plosser said the FOMC could also use the IOER as its policy rate instead of the funds rate, to establish a floor for market rates. But he said such a framework "implies that the size of the Fed's balance sheet is technically indeterminate and could expand to be very large without necessarily affecting the implementation of monetary policy."

"I am skeptical of such an approach and prefer the corridor system, in part because it constrains the size of the balance sheet," he said. "A corridor system makes it less likely that the Fed's balance sheet could be used for purposes outside the purview of monetary policy."

"The fed funds rate is also more familiar to markets and policymakers, and because it is a market rate, rather than an administered rate like the interest rate paid on reserves, it offers policymakers more feedback on market pressures when setting policy," he added.

Plosser warned that "to ensure that the fed funds rate trades above the interest rate on reserves, normalization will require a significant reduction in the volume of reserves in the banking system, which will result in a much smaller balance sheet for the Fed."

In advocating an early tapering of asset purchases, Plosser gave an upbeat assessment of the economic outlook. He downplayed current inflation risks but cautioned against longer term threats.

Plosser said that consumer spending should strengthen as household deleveraging continues to wane. He projected real GDP growth of at least 3% this year and next and said the unemployment rate should fall to 7% by the end of 2013 and to 6.5% by the end of 2014. The latter rate is the FOMC's "threshold" for considering rate hikes.

With inflation running below the FOMC's 2% target, he said he does "not see inflation as a serious threat in the near term."

"However, I remain concerned that our extraordinary level of monetary accommodation will have to be scaled back, perhaps more aggressively than some think, to ensure that inflation over the medium term remains consistent with our target," he added.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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