The Fed’s own beige book survey finds many manufacturers and retailers are passing along higher costs to customers. Nevertheless, the FOMC majority feels it is missing on both sides of its "dual mandate" and hence is justified pursuing a highly accommodative policy and doesn’t want to get ahead of itself.
Although monetary normalization seems far down the road, exit tools are increasingly on policymakers’ minds, if only to reassure markets they are willing and able to tighten when the time comes. Most members lean toward raising the rate of interest paid on excess reserves (the IOER) and, in turn, other short-term interest rates as the first step. They are inclined to delay actively shrinking the balance sheet. But the FOMC likely will leave its options open and tailor its exit strategy to changing circumstances.
Market expectations will play a key role. The FOMC may want to tighten in its usual manner. But if growth accelerates faster than anticipated and/or inflation and inflation expectations move up, it may prefer more aggressive firming.
That could present problems, though. When the FOMC last began raising the funds rate in June 2004, following a year-long stay at 1%, it did so in a slow, "measured pace," taking the funds rate up to 5.25% in 25-basis-point steps at 16 successive meetings. Memories of that tediously predictable approach could condition market reactions. To get a stronger reaction, the FOMC may consider some balance sheet reduction.
A hybrid approach is possible using a combination of the rate and balance sheet channels. Also, the exit strategy may need to change as the Fed finds its way. Communication will be key. To avoid the appearance of being locked into a perpetually incremental tightening pace and leave itself the option of taking larger steps, the FOMC may want to avoid such phraseology as "measured pace."
The FOMC’s longstanding pledge to keep rates "exceptionally low...for an extended period" will have to go at some point. Vice Chairman Janet Yellen indicated that the Fed would have flexibility regarding that guidance.
There are other issues to ponder. Officials have expressed hope that raising the IOER will pull up the funds rate, but they aren’t sure. Because government sponsored enterprises can’t earn interest on reserves, and thus have little incentive to hold them, the gap between the IOER and funds rate could widen. The Fed could conduct policy effectively if the gap is relatively small and steady, but if it becomes large and unpredictable, then that would complicate the New York Fed open market desk’s operations and force it to drain reserves.
Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of "Back From The Brink: The Greenspan Years" (Wiley).