Calling the “normalization of the federal funds rate … well under way,” Federal Reserve Board Governor Lael Brainard said it is almost time for balance sheet run off.

“I consider normalization of the federal funds rate to be well under way,” Brainard said at a conference in New York, according to prepared text released by the Fed. “If the data continue to confirm a strong labor market and firming economic activity, I believe it would be appropriate soon to commence the gradual and predictable process of allowing the balance sheet to run off.”

Federal Reserve Board Governor Lael Brainard.
Federal Reserve Board Governor Lael Brainard. Bloomberg News

Once the Fed starts reducing its balance sheet, she said, “I will want to assess the inflation process closely before making a determination on further adjustments to the federal funds rate in light of the recent softness in core PCE (personal consumption expenditures) inflation.”

The real neutral rate will stay close to zero over the medium term, she said, so “we would not have much more additional work to do on moving to a neutral stance.”

Inflation would have to be monitored carefully to make sure it will return to the Fed’s 2% target.

While the U.S. has started raising interest rates, Brainard said other central banks are also “seeing conditions that suggest policy normalization could be on the table before too long, against the backdrop of a brighter global outlook.”

Given these circumstances, “the pace and timing of” normalization “could have important implications for exchange rates and financial conditions globally,” she said.

While hiking interest rates was the only choice central banks had to remove accommodation after prior downturns, balance sheet runoff is a second option now. Both “appear to affect domestic output and inflation in a qualitatively similar way,” making them interchangeable. Central banks will use other factors, she said, such as “the ease of implementing and communicating policy changes, or the desire to minimize possible credit market distortions associated with the balance sheet.”

As for spillover, Brainard suggested the effects may be different for raising rates and reducing the balance sheet. “The balance sheet might affect certain aspects of the economy and financial markets differently than the short-term rate due to the fact that the balance sheet more directly affects term premiums on longer-term securities, while the short-term rate more directly affects money market rates. As a result, similar to the domestic effects, while the international spillovers of conventional and unconventional monetary policy may operate broadly similarly, the relative magnitude of the different channels may be sufficiently different that, on net, the two policy strategies have distinct effects.”

The exchange rate might “be more sensitive to the path of short term rates than to balance sheet adjustments,” she said research suggests.

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