NEW YORK - Federal Reserve Board Vice Chairman Donald Kohn Thursday said that a "large, rapid" rise in short-term interest rates is "quite improbable" given that the global economy is "quite weak" and that inflation is "low."
Even if short-term rates and in turn the rate of interest the Fed pays on bank reserves does rise sharply, he said the Fed's earnings would likely outweigh its interest costs.
Kohn, in remarks to the Washington-based Brookings Institution, said the Fed is continuing tools to "drain or neutralize" reserves in an effort to help it shrink the size of its balance sheet and to "tighten the link" between the interest rate it pays on reserves and short-term interest rates such as the funds rate.
He expressed skepticism of proposals to have the Fed target a higher rate of inflation in an effort to reduce real interest rates and help spur recovery. He said the Fed's advertised "extended period" of "exceptionally low" rates is designed to bring down real rates.
Kohn was commenting on a paper presented by Ricardo Reis, which among other things expressed concern about the mounting cost of paying interest on reserves and how that might damage the Fed's relations with Congress as well as the Treasury, and in turn the Fed's ability to independently run monetary policy. (The Fed annually pays a large profit from its operation to the Treasury, and that will be reduced by the amount of interest the Fed pays banks and other depository institutions -- a power it acquired last October.)
"This outcome seems extremely remote," Kohn said. For one thing, he said, "the Federal Reserve's exposure to credit losses is quite
limited."
"Certainly, the Federal Reserve's interest expense will increase when short-term rates move up from the current very low level because of the payment of interest on reserve balances," he acknowledged. "However, the Federal Reserve will continue to earn substantial net income over the next few years under all but the most remote contingencies, for at least two reasons: first, currency, on which we pay no interest, will remain a substantial a portion of our liabilities; and second, we will have sizable earnings on our assets. Short-term interest rates would have to rise very high very quickly for interest on reserves to outweigh the interest we are earning on our longer-term asset portfolio."
Kohn said that "with the global economy quite weak and inflation low, a large and rapid rise (in rates) seems quite improbable."
"Moreover, even in the unlikely event that a sharp rise in interest rates forced us to suspend remittances to the Treasury temporarily, we would still maintain our ability to implement monetary policy to foster our statutory objectives of maximum employment and stable prices," he added.
Kohn said that paying interest on reserve balances "will play a key role in our exit from unusually accommodative policies when the time comes" because "raising the interest paid on those balances should provide substantial leverage over other short-term market interest rates because banks generally should not be willing to lend reserves in the federal funds market at rates below what they could earn simply by holding reserve balances."
The Fed hopes that, as it raises the funds rate target, a commensurate rise in the rate of interest it pays on reserves will set a floor under the effective funds rate by discouraging banks from lending their excess reserves into the funds market.
Explaining why the Fed is also emphasizing the need to use other tools to "neutralize or drain" reserves, as it did in the minutes of the August Federal Open Market Committee meeting, Kohn said, "Neutralizing or draining reserves could be helpful in tightening the link between the interest rate on excess reserves and other short-term interest rates."
"And the presence of a large volume of reserves on bank balance sheets -- even when remunerated -- could have undesired effects on the portfolio decisions of banks," he said. "So we continue to develop tools that enable the Federal Open Market Committee (FOMC) to drain or neutralize large volumes of reserves were the Committee to decide that doing so would support its objectives."
Among the "other tools" being considered, as reflected in the FOMC minutes and the July Monetary Policy Report to Congress, are the use of reverse repurchase agreements and giving banks the opportunity to hold their reserves in term deposits at the Fed.
In the brief time in which the Fed has been paying interest on reserves it has sometimes had difficulty using it to set a floor under the funds rate -- to keep it from trading below target. Hence the search for ways to "tighten the link" between the rates.
In a footnote, Kohn notes "there are large participants in the federal funds market -- the housing government sponsored enterprises -- that are not eligible to receive interest from the Federal Reserve and thus may be willing to make reserves available in the federal funds market at rates lower than the interest rate paid on reserves."
In another footnote elaborating on how the Fed could "tighten the link," he writes, "the Federal Reserve could drain liquidity by engaging in reverse repurchase agreements with a range of counterparties, or it could offer banks the option of term deposits, which would then not be available for lending in the federal funds market."
"The Federal Reserve could also sell a portion of its holdings of securities," he continues. "Any combination of these tools, in addition to the payment of interest on reserves, may prove very valuable when the time comes to tighten the stance of monetary policy -- though, as the FOMC has said, that time is not likely to come for an extended period."
Responding to suggestions that the Fed target "higher-than-normal inflation rates even beyond the point of economic recovery, so that real interest rates decline by more and thus provide greater stimulus for the economy," Kohn was dubious.
"The arguments in favor of such a policy hinge on a clear understanding on the part of the public that the central bank will tolerate increased inflation only temporarily -- say, for a few years once the economy has recovered -- before returning to the original inflation target in the long term," he said. "Notably, although many central banks have put their policy rates near zero, none have adopted this prescription," he said.
"In the theoretical environment considered by the (Reis) paper, long-run inflation expectations are perfectly anchored," he said. "In reality, however, the anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted."
Kohn warned that "a policy of achieving 'temporarily' higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high."
Nevertheless, although the Fed "has not attempted to raise medium-term inflation expectations," Kohn said "it has taken numerous steps to lower real interest rates for private borrowers and keep inflation expectations from slipping to undesirably low levels in order to prevent unwanted disinflation."
Among those steps, he said is "the provision of forward guidance that the level of short-term interest rates is expected to remain quite low 'for an extended period' conditional on the outlook for the economy and inflation, and the publication of the longer-run inflation objectives of FOMC members."
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