Boston Federal Reserve Bank President Eric Rosengren Monday said if he had things his own way the Fed would not implement the first increase in interest rates until the U.S. economy is 12 months away from the central bank’s jobs and price stability goals.
In remarks prepared for delivery to a conference in Guatemala City, Guatemala, Rosengren also suggested that, with future financial stability in mind, the Fed should consider a gradual tapering of its portfolio reinvestment policy when the time comes, in a similar manner to its current meeting-by-meeting adjustment of its monthly large-scale bond purchases.
Rosengren will not hold a voting position on the policymaking Federal Open Market Committee until 2016, a year after the Fed is expected to have already departed from its zero rate policy.
“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% inflation,” Rosengren said, although he acknowledged “that is my personal view.”
While telegraphing potential decisions down the road will be key to the Fed exiting its highly accommodative monetary policy without roiling financial markets, Rosengren also cautioned that “it is important to avoid binding specificity about future actions, since policies should be responsive to actual conditions as clarity emerges about the strength of the economy and the impact of various tightening tools.”
Still, the move to a higher interest rate environment, and the manner in which the Fed tightens policy, will have an impact on financial stability, and it is something Rosengren said the Fed is paying “significant attention” to.
Currently, however, Rosengren noted that volatility in the market for U.S. government debt remains quite low despite the FOMC’s wind down of its asset purchases, presently at $45 billion a month.
“I would attribute that in part to the very gradual and predictable reduction in the purchase program, along with an economy that has continued to improve, albeit only gradually and with some setbacks along the way,” he said.
The Fed should draw a lesson from this experience, Rosengren said, adding the “benign” market reaction to the gradual end of quantitative easing may provide an answer to the best way to shrink the Fed’s swollen balance sheet.
“While the optimal program for reducing the Fed’s balance sheet will need to be dependent on the state of the economy, the recent tapering experience suggests to me that a predictable, transparent reduction in the balance sheet could be done in ways that may minimize the risk of financial disruption,” he said.
He offered up a sample scenario in which a reduction in the balance sheet, when the time comes, “could be implemented as a basically seamless continuation of the tapering program used for reductions in the purchase program. For example, the Committee could decide to reinvest all but a given percentage of securities on the balance sheet as they reach maturity, and increase that percentage at each subsequent meeting, assuming conditions allow.”
Rosengren argued that this approach could allow the Fed to implement a gradual and transparent reduction in its portfolio.
“As the economy moved closer to the Federal Reserve’s 2% inflation target and full employment, there could be a gradual reduction in the reinvestment policy – which would allow for a predictable reduction in the size of the balance sheet,” he said.
However, given his counsel against committing to binding policy, he stressed that the pace of reinvestment should always be considered in the context of the economy’s performance.
“If the economy was substantially stronger or substantially weaker than was expected, the reinvestment program would need adjustment,” he said.
Rosengren also discussed the significant increase in excess bank reserves, and how that could impede the standard tools the Fed uses for raising the target federal funds rate. To counter this, he said when it is appropriate to start raising rates, the Fed could increase the rate of interest that the Federal Reserve pays on excess reserves.
“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,” Rosengren said.
He cautioned, however, that since only banks hold reserves, the effect of this action 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.”
In order to exert more control over short-term rates, Rosengren said the Fed could utilize overnight reverse repos – a facility the New York Fed currently is testing.
“Because reverse repo transactions can involve a broader set of counterparties than just the banking system, this tool might have a more reliable effect on short-term market interest rates,” he said.
Rosengren noted that a positive impact of these tools would be that the Fed would have the ability to control short-term rates independent of the size of its balance sheet.
“This means the Federal Reserve could have additional financial stability tools at its disposal, if it chose to maintain a larger-than-balance sheet with a greater mix of assets,” he said, as having a large portfolio made up of both U.S. Treasury securities and mortgage-backed securities “would provide the Federal Reserve with continuing options for impacting long-term interest rates and the spread between mortgage-backed securities and U.S. Treasury securities.”
For example, the Fed could sell MBS or longer-term Treasuries to address a bubble that the central bank believed was developing in housing markets generally, Rosengren said.
Overall, normalizing monetary policy will not be without its challenges, Rosengren acknowledged.
“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,” he said, “this is not a traditional area of expertise for most central banks, but we are making strides and improving.”
The current period of “relative calm” in the financial markets may be challenged in the future, Rosengren warned, adding that the eventual departure from very low interest rates by the Fed and other central banks will also be unprecedented, presenting challenges of communication and understanding.
For now, despite the uptick in interest rates following last May’s ‘taper tantrum’, Rosengren said the U.S. economy has continued to improve. That is not to say there has been no impact: “some of the recent slowdown in housing activity is likely attributable to the rise in mortgage rates in the wake of last year’s market adjustment.
“In sum, this episode made clear the importance of Federal Reserve communication and market understanding about programs and policies. The episode also underlined the importance of calibrating investor reactions into models of policy impact.”