The Federal Reserve has been planning for monetary policy normalization and is prepared to meet the challenges of removing accommodation when it occurs, Federal Reserve Bank of Cleveland President and Chief Executive Officer Loretta J. Mester said early Monday.
The Fed needed to take "unprecedented policy actions in response to the financial crisis and deep recession," Mester told an audience in Paris, according to prepared text released by the Fed. "These extraordinary actions helped support progress toward the Fed's goals of price stability and maximum employment. At the same time, they present some challenges for the return to ordinary monetary policymaking. But the FOMC has plans to address those challenges. It has laid out how it anticipates conducting monetary policy during normalization."
Mester also cited the changes in the Fed's forward guidance as an effort to work toward normalization.
"Most times in life, moving from extraordinary to ordinary is considered a bad thing," she said. "In the case of monetary policy, such a move should be viewed as a good thing - because it means conditions are in place for a sustainable economic expansion with maximum employment and price stability."
The rise in the Fed's balance sheet to $4.5 trillion from less than $900 billion in July 2007 as well as the changes in guidance "raised some challenges about how to move back from extraordinary monetary policy to ordinary monetary policy, what the Fed has called normalization," Mester noted.
But, the FOMC has been getting ready for policy normalization as early as June 2011, when it laid out exit principles, which were updated last September.
"Just as it did before the Great Recession, the FOMC plans to implement monetary policy by adjusting short-term interest rates," she added. "It will communicate changes in the stance of policy by changing the target range for the fed funds rate."
Since banks hold more excess reserves now, the Fed needs to use different tools than it would have before the crisis. The main tool the Fed will employ is the interest rate it pays on excess reserves (IOER), she said. "Raising the IOER rate will put upward pressure on the fed funds rate because banks will be unlikely to accept a rate in the market lower than the one they could get by depositing their funds at the Fed. We expect that while reserves are so plentiful and because not all financial institutions holding reserves are eligible to receive interest, the fed funds rate will trade somewhat below the IOER rate."
The fed will also use overnight reverse repurchase agreement facility, when necessary, to adjust rates. "The FOMC has indicated that the overnight reverse repo facility will be used only to the extent necessary and will be phased out when no longer needed to help control short-term interest rates. This will help to ensure that the facility doesn't lead financial institutions to permanently change the way they do financial intermediation."
Also, the Fed "has been testing usage caps on overnight reverse repos and other design features. These would help mitigate the possibility that during times of financial stress the facility would attract liquidity from the market, thereby increasing the level of stress in the market. And the Fed is considering other tools, like term deposits and term RRPs, that could absorb some of the excess reserves in the banking system," Mester said.
