NEW YORK – With the economy strengthening, Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser Friday took the opportunity to layout his preferred policy accommodation exit strategy, which should be implemented in the “not-too-distant future,” and includes simultaneously raising rates and shrinking the balance sheet, while tying the pace of asset sales to the pace and size of interest rate increases.
“Failure to do so in a timely manner,” he warned, “could have serious consequences for inflation and economic stability in the future.”
First, Plosser said, he would “move away from the zero bound and stop the reinvesting program and allow securities to run off as they mature,” which would raise the interest paid on reserves to 50 basis points from 25 basis points and set a funds rate target of 50 basis points.
“We would also announce that between each FOMC meeting, in addition to allowing assets to run off as they mature or are prepaid, we would sell an additional specified amount of assets,” Plosser told the Shadow Open Market Committee symposium, according to prepared text of his remarks, which was released by the Fed. This would gradually shrink the balance sheet, and thus reserves.
Part two of the strategy would be to have the FOMC evaluate incoming data at each meeting to determine whether to raise rates. “Monetary policy should be conditional on the state of the economy and the outlook,” Plosser said. “If the funds rate and interest on excess reserves do not change, the balance sheet would continue to shrink slowly due to run-off and the continuous sales. On the other hand, if the FOMC decides to raise rates by 25 basis points, it would automatically trigger additional asset sales of a specified amount during the intermeeting period. This approach makes the pace of asset sales conditional on the state of the economy, just as the Fed’s interest rate decisions are.”
The final part of the exit plan would address the Fed’s portfolio. “If we are to return to an all-Treasuries portfolio, then asset sales, particularly in the early part of the program, must be concentrated in MBS,” he said.
Critics, Plosser suggested, would say such a rapid shrinking of the balance sheet would disrupt markets, but “in a growing economy, the demand for duration and risk is likely to be increasing and this will mitigate any potential for disruption.”
Also, the asset purchase programs mostly influenced long-term rates by changing the amount of these assets in the hands of the public and not through the flow or pace of purchases. “Once the markets understand that the FOMC has begun to normalize policy and that the Fed is shrinking its portfolio and the volume of excess reserves, then the stock effect will largely be incorporated into long rates and the pace of sales will have only marginal effects,” Plosser said, “Thus, whether it is through expected higher short-term rates or through the sale of longer-term securities, long rates will and should rise during the tightening cycle.”
Asset purchases, Plosser said, except when the markets were severely impaired, “had, at best, marginal effects on asset returns and economic activity. Given that market functioning has returned to normal, I believe asset sales are unlikely to have a significant impact as market participants’ demand for risk and duration rise.”
The two-front strategy is better than allowing the balance sheet to decline as securities mature, Plosser said, because “No one knows how fast the Fed might have to raise rates to restrain the huge volume of excess reserves from flowing out of the banking system. Rates might have to rise very quickly and in larger increments than otherwise to offset the accommodative impact of the large balance sheet. This could prove quite disruptive, yet failing to do so could risk much higher inflation levels. It also means that it would take about five years before the funds rate would become a feasible operating instrument. This approach also fails to address the problem of the composition of the balance sheet, since, at the end of the process, the SOMA portfolio would still remain heavily invested in mortgage-backed securities. Another drawback of this alternative is that while the Fed’s interest rate decisions would be contingent on the state of the economy, decisions regarding the size and composition of the balance sheet would not be.”
Plosser rejected an alternate approach could be to sell assets and shrink the balance sheet first, as” a somewhat risky strategy, because if the pace of sales is not sufficiently aggressive, the policy rate may fall far behind the curve to stave off higher inflation.”
The economy “gained significant strength and momentum since late last summer and seems to be on a much firmer foundation going forward,” Plosser said. The weakness in real estate, he added, will not prevent a broader economic recovery, and “the nonresidential real estate sector is likely to improve as the overall economy gains ground.”
While the situation in Japan and the turmoil in the Middle East and North Africa threaten the recovery, Plosser said, “I believe this risk is small and short term, assuming Japan is able to stabilize its nuclear reactors and political unrest in the Middle East does not dramatically disrupt Saudi Arabia, the region’s largest oil producer.”
In the future, Plosser wants to “re-establish the federal funds rate as the primary instrument of monetary policy; shrink the balance sheet and reserves to levels that make the federal funds rate an effective policy tool; and restructure the balance sheet in terms of its composition and maturity structure. Adopting an explicit inflation objective would contribute to the effectiveness of policy and the policy framework and any plan for normalization.”
