Although the economy has recovered slowly from the Great Recession, progress should allow the Federal Reserve to raise interest rates this year, Federal Reserve Board Vice Chair Stanley Fischer said Monday.
"An increase in the target federal funds range likely will be warranted before the end of the year," Fischer told the Economic Club of New York, according to prepared text released by the Fed. "Liftoff should occur when the expected return from raising the interest rate outweighs the expected costs of doing so."
Fischer said "a wide range of information" will be considered and the rate target will be lifted "when there has been further improvement in the labor market and we are reasonably confident that inflation will move back to our 2 percent objective over the medium term."
But, he noted, as long as the Fed's balance sheet "remains sizable," traditional tools will not be successful in implementing monetary policy. "It is important that, when we change the rate for the first time in a long time, we are certain that we have the operational tools to control the federal funds rate-and, accordingly, we have developed and tested new operational tools to control the federal funds rate," Fischer said.
Fischer detailed the normalization principles outlined by the Federal Open Market Committee, which employs "the rate of interest on excess reserves (IOER)" as the primary tool to control the federal funds rate, with assistance from overnight reverse repurchase agreement (ON RRP) facilities, when needed.
"In addition, the Fed has been discussing and testing other supplementary tools, such as term reverse repurchase agreements and term deposits, and can use these tools as needed to help support money market rates," Fischer said. "With regard to balance sheet normalization, the FOMC has indicated that it does not anticipate selling agency mortgage-backed securities. When the time comes, we plan to normalize the balance sheet primarily by ceasing reinvestment of principal payments on existing holdings. When the FOMC chooses to cease reinvestments, the balance sheet will naturally contract, with a corresponding reduction in reserve balances. This runoff of our securities holdings will also gradually remove accommodation, an effect that we will need to take into account in setting the stance of policy."
Other tools and adjustments could be developed and used, as necessary. "In part because of this adaptability, I am confident that by using IOER and, as needed, these supplementary tools, we will be able to raise short-term interest rates when it becomes appropriate," he said.
Fischer said the FOMC needs to plan beyond liftoff. "For liftoff is only the start of the process of normalization, and, going forward, the FOMC will once again be changing the federal funds rate as necessary, both up and down. Accordingly, discussion of monetary policy needs to begin to shift to the future path of interest rates, and thus to the basis on which the FOMC will set interest rates following liftoff."
Discussions of an earlier liftoff with a gradual increase in rates, or a later liftoff with large rate hikes have been "useful," he said. "But what comes after the first increase? Standard interest rate projections might incline one to believe that the path of the federal funds rate after liftoff will consist of a steady rate of increase from zero to the longer-run normal nominal federal funds rate, which will be equal to the natural real rate of interest plus our 2 percent inflation goal," he suggested. "One might even look back to the period from 2004 to 2007 and conclude that the FOMC will raise the federal funds rate by 25 basis points every meeting, or every second meeting, or every third meeting, depending on the date of liftoff.
"I know of no plans for the FOMC to behave that way. Why not? Isn't that what the calculation of optimal control paths shows? Yes. But a smooth path upward in the federal funds rate will almost certainly not be realized, because, inevitably, the economy will encounter shocks--shocks like the unexpected decline in the price of oil, or geopolitical developments that may have major budgetary and confidence implications, or a burst of greater productivity growth, as the Fed dealt with in the mid-1990s. When shocks happen, as they do, policymakers will have to respond to at least some of them. Accordingly there is considerable uncertainty about the level of future interest rates--a degree of uncertainty that can be estimated statistically, and that should be taken into account by market participants and recognized by the FOMC when it discusses future levels of interest rates."
Fischer said after liftoff, the Fed will continue to use monetary policy to meet its dual objectives and "will continue to be absolutely transparent in explaining its decisions and how and why they contribute to meeting the legally mandated dual goals of monetary policy."
