Short-term interest rates should be raised when the U.S. economy is within a year of reaching both full employment and about 2% inflation, Federal Reserve Bank of Boston President & Chief Executive Officer Eric S. Rosengren said Monday.
"I personally do not expect that it will be appropriate to raise short-term rates until the U.S. economy is within one year of both achieving full employment and returning to within a narrow band around 2 percent inflation," Rosengren said in a speech in Guatemala, according to prepared text released by the Fed. "Again, that is my personal view. However, both the transition to higher rates and the operating procedure for doing so could entail financial stability effects that should be thoughtfully considered - and I am certain will be."
Praising the Fed's efforts since the financial crisis as "instrumental in achieving better economic outcomes," Rosengren said the policies "are not without challenges."
The exit strategy interests market participants. "Uncertainty or misunderstanding about the contours of our exit has the potential to be problematic in both advanced and developing economies - as we were reminded a year ago - so effective and transparent communication has become even more important than in the past," Rosengren said.
While better communication has smoothed things recently, "we should all acknowledge the possibility that this relative calm may be challenged in the future," he said. "The eventual exit from very low interest rates around much of the globe will also be unprecedented, and will thus hold challenges for communication and understanding. Having said that, I would observe that the careful consideration of all of the aspects of the exit strategy provides opportunities to consider a broader set of monetary policy tools, and how those tools impact financial stability along with inflation and unemployment."
The asset purchase program, Rosengren said, "encouraged private sector investors to purchase a wide array of long-term assets, lowering long-term interest rates and helping many asset prices rebound - and thus amplifying the impact of the Federal Reserve's actions."
But, investors who bought assets hoping for price gains "as the Federal Reserve pursued its expansionary policy were likely to be quite sensitive to the reversal of these policies." And, with that reversal's timing "quite uncertain," it made it difficult to protect against that risk.
The "benign reaction" to the taper could offer clues to how to wind down the Fed's balance sheet, Rosengren noted. Although economic conditions will play a role, "a predictable, transparent reduction in the balance sheet could be done in ways that may minimize the risk of financial disruption."
He suggested one option "could be implemented as a basically seamless continuation of the tapering program used for reductions in the purchase program" by not reinvesting a portion of securities on the balance sheet as they mature, and increasing the amount not reinvested at subsequent meetings, if conditions allow.
With an elevated level of excess reserves in the system, "the standard tools for raising the federal funds rate are not available to the Fed," Rosengren noted, "a variety of other tools" can be employed.
"One possible strategy, when it is appropriate to start raising rates, is to raise the rate of interest that the Federal Reserve pays on excess reserves," Rosengren said. "Banks will be unwilling to hold other assets that do not pay at least the rate of interest on excess reserves, so this should raise short-term market interest rates even in the presence of substantial excess reserves. However, since only depository institutions hold reserves, the effect of this rate on other market rates may be somewhat muted, leading some short-term interest rates in the marketplace to trade below the interest rate on excess reserves."
The Fed can also use overnight reverse repurchase agreements, with one concern: "during a period of heightened financial risk, investors might flee to the reverse repo market. This would provide a safe asset for investors, but might also encourage runs from higher-risk, short-term private debt instruments. This would have the potential to create significant private sector financing disruptions during times of stress. Presumably, capping the size of the reverse repo facility could help limit the impact."
