ARLINGTON, Va. - The central bank is preparing for one of the most complex tightening cycles it has ever faced but has the tools needed and is in position to minimize the risk of the dueling factors, a senior Federal Reserve official said Monday.
Brian Sack, executive vice president of the New York Federal Reserve Bank, said details on the method and timing of the various stages of the exit strategy will be up to the policy-setting Federal Open Market Committee, but the tools are or will soon be in place.
"When the time comes to tighten monetary policy, the Federal Reserve will be embarking on a tightening cycle like no other in its history," Sack said in a speech to the National Association for Business Economics Policy Conference.
The FOMC's job will be complicated by the need "to decide on the path of its asset holdings in addition to the path of the short-term interest rate," he said.
Policymakers also "will be using tools to drain reserves that are new and that will have to be implemented on a scale that the Fed has never before tried;" and will be "operating in a framework of interest on reserves that has not been fully tested in U.S. markets."
"However," Sack said, "I believe the Federal Reserve is positioned to minimize any risks involved," and will have the tools it needs to execute the exit. "In addition, if we communicate effectively, the markets should be clearly informed and well prepared ahead of the exit."
He noted that the Fed's short-term liquidity facilities which have come to an end have been an "unquestionable success," and the exit has been "quite smooth" without any major problems for financial markets or institutions.
Responding to questions on the subject following his speech, Sack said providing liquidity to "more than just depository institutions" is the appropriate response in a crisis, but it will be worthwhile at some point "to carefully look back and evaluate the programs ... to see what worked."
The Fed's expanded balance sheet poses a different set of problems, he said. He noted that the "purchase programs have helped to hold down longer-term interest rates, thereby supporting economic activity" but the portfolio balance effect means rates have remained low even as asset purchases have tapered off.
The "FOMC has to carefully take into consideration how it will manage the size of its balance sheet going forward" since this effect potentially means "the size of the Fed's asset holdings becomes a relevant policy lever."
The "crucial message for markets" from Fed Chair Ben Bernanke's recent testimony is that the FOMC will be "shrinking its balance sheet in a gradual and passive manner," Sack said, which would leave "the adjustment of short-term interest rates as the more active policy instrument."
He noted the Fed has been "developing two tools that can be used to reduce the large amount of excess reserves in the banking system-term deposits with banks and reverse repurchase agreements (reverse repos) with a broader universe of financial institutions."
Earlier Monday the Fed announced criteria for allowing money market funds to become eligible counterparties to the reverse repos, and Sack said they expect "to have arrangements in place and to be ready to transact with some non-dealer firms by the end of the second quarter."
Asked about the possibility of GSEs serving as counterparties, Sack declined to comment.
In addition, he said "work on using MBS holdings as collateral is nearly complete, and we will likely conduct some small-scale operations with MBS collateral in a month or so to exercise that capability."
"The bottom line is that the preparation of both facilities is advancing very effectively. Looking across the two programs, we will have established the capacity to drain a significant portion of 7 excess reserves by the second half of the year," Sack said.
But he cautioned: "Of course, achieving this capacity does not say anything about how and when the FOMC will decide to actually drain reserves."
Sack noted that Bernanke suggested the Fed might remove excess reserves before beginning to increase the interest rates paid on reserves, which "should improve the Fed's control of short-term interest rates when it comes time to tighten monetary policy."
In response to a question after the speech, Sack said it may turn out the system "may function better with a larger amount of reserves than it had before the crisis" though that decision remains up to the FOMC.
Sack said the potential for confusion about Fed action as well as lack of preparedness for the exit are two potential risks to the exit strategy, but the FOMC's "forward looking" policy language in its policy statements should help with the former.
And as to the latter, the configuration of market yields and prices "incorporates expectations that short-term interest rates will begin to rise around the end of this year. Thus, the markets seem prepared for the risks toward tighter policy," Sack said.
While the challenges associated with the Fed's exit strategy "will inherently involve some uncertainties and risks," Sack said, "the Federal Reserve's efforts to date should minimize those risks."
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