NEW YORK (MNI) – The following is the third and final part of the
text of a speech by Charles Plosser, president of the Federal Reserve
Bank of Philidelphia to the Shadow Open Market Committee in New York on
the framework for long-run monetary policy, March 25:
Examples of the Exit Strategy Continued:
To illustrate my proposed exit strategy, I want to consider two
examples. In the first example, assume after the initial rise to 50
basis points, the path of policy involved raising the interest rate by
25 basis points at each of the next eight meetings over the following
year, and suppose the pace of conditional sales was $125 billion. That
is, for each 25 basis point increase in the funds rate, we would sell an
additional $125 billion of assets. I note that this pace of conditional
sales, combined with the continuous sales and run-off, is similar to the
pace at which the Fed bought securities as the balance sheet expanded.
Then the funds rate and the interest rate on reserves would rise to
2.5 percent and the balance sheet would shrink by $1.45 trillion by the
end of a year, or eight FOMC meetings. Monetary policy would still be
accommodative, but the operating framework would be normalized. We
would have shrunk the amount of excess reserves in the banking system so
that the funds rate could once again be the policy instrument and the
balance sheet would no longer be an issue for policy.
In the second example, let’s suppose we wanted to normalize policy
in 18 months rather than a year. That would mean normalizing over
twelve FOMC meetings rather than eight. This would require conditional
sales of only $67 billion between meetings, but it would also mean that
the funds rate would become a viable instrument at 3.5 percent rather
than 2.5 percent. These two examples illustrate how the pace of sales
and the time it takes to normalize policy involve trade-offs that must
be faced.
Discussion
I recognize that any strategy has its disadvantages and this one,
no doubt, will attract its share of critics. Some will say that we
cannot shrink the balance sheet this rapidly without disrupting markets.
Yet the pace of sales in the first example is likely to be no more rapid
than the pace of asset purchases during the crisis, and in a growing
economy, the demand for duration and risk is likely to be increasing and
this will mitigate any potential for disruption.
Moreover, many advocates of the asset purchase programs have argued
that these programs mainly influenced long-term rates by changing the
amount of these assets in the hands of the public – the so-called stock
effect – and not through the flow or pace of purchases. This is why
announcing the total amount of purchases up-front was an important part
of the asset purchase programs.
According to this stock view, 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. 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.
My own view is that except for the period when markets were
severely impaired, early in the crisis, the asset purchase programs 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.
Others have suggested that we simply rely on raising interest rates
and allowing the balance sheet to decline only slowly over time through
the natural run-off of maturing securities. In my view, this
alternative has several drawbacks. 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.
Another, perhaps somewhat more appealing approach is to shrink the
balance sheet first through the sale of assets. This might be thought
of as the LIFO model – last in first out. The asset purchases came
after the policy rate reached the effective zero bound, so some argue
that assets should be sold first before raising the policy rates from
the zero bound. I think this is 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.
For these reasons, the approach that I have outlined involves
concurrent policy rate increases and asset sales whose pace depends on
the state of the economy. Of course, as my examples illustrate, this
approach can be modified by changing the numbers. You could make the
balance sheet shrink faster or slower and affect the timing of when
normalization is achieved, or you could increase the pace of continuous
sales and make the conditional sales smaller. But whatever pace we
decide on, I believe it is important that we articulate a systematic
approach to normalizing monetary policy. We must have a plan that we
can communicate to the markets that indicates where we are headed and
how we anticipate getting there.
Closing Thoughts
In summary, I believe that my proposed exit strategy has several
advantages. It can get us back to a “normal” operating environment in a
timely manner. It shrinks excess reserves sufficiently in a timely
manner after the process begins so that the federal funds rate can once
again be the primary policy instrument. It is a plan that can be easily
communicated in a way that the markets and the public can understand.
By tying sales to interest rate decisions, it allows the process for
selling assets to be conditional on economic outcomes in ways that are
familiar to market participants. This should provide a degree of
comfort to the markets and reduce uncertainty about the path of sales.
I believe that the challenges the FOMC faces as it exits from the
period of extraordinary accommodation and nontraditional policies can be
reduced if we communicate a systematic plan that describes where we are
headed and how we will get there. Such a plan would be strengthened if
the FOMC adopted an explicit numerical objective for inflation. Doing
so will help ensure that inflation expectations remain well anchored,
thereby reducing the risks of undesirable inflation outcomes as we
choreograph a graceful exit.
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