Federal Reserve officials concur on the need to withdraw their extraordinary monetary stimulus in a “timely” way to contain inflation, but that’s about where the consensus ends.
The timing and preferred methods of eventual credit tightening remain matters of great uncertainty. And there is a lively internal debate over which “exit strategy” tools to use and in what order.
Fed Chairman Ben Bernanke and his colleagues have spent considerable time talking about their ability and willingness to use those tools to withdraw excess liquidity and normalize rates when the time comes — in part, one suspects, to reassure foreign exchange and other markets and control inflation expectations.
But the Federal Open Market Committee (FOMC) has kept its federal funds rate target between zero and 25 basis points for more than a year and there is no near-term end in sight. Barring an unexpectedly robust recovery or a surprising jump in inflation, it is hard to imagine any meaningful move toward the exits before mid-year.
Exactly when the Fed decides to start tightening — or more precisely when it begins making policy less accommodative — will obviously depend on how economic and financial conditions evolve. But, as the FOMC said in releasing its revised three-year forecast in late November, there is more than the usual uncertainty about the outlook.
That forecast tells you a lot. Despite obvious improvements in housing, manufacturing and financial markets, the Fed continues to expect the recovery to be sluggish. Despite the third-quarter upturn in GDP, the Fed made only slight upgrades to the coming years. It projects painfully slow reductions in unemployment from November’s 10% to 9.3% to 9.7% in 2010; 8.2% to 8.6% in 2011.
The Fed is counting on “substantial resource slack” to keep inflation “subdued for some time” despite its easy money stance. The FOMC projects PCE inflation at 1.3% to 1.6% in 2010; 1.0% to 1.9% in 2011; 1.2% to 1.9% in 2012 and 1.7-2.0% “longer run.” Those forecasts assume “appropriate monetary policy.”
But Fed officials have made it abundantly clear they are in no hurry to firm policy, explicitly stating federal funds rate would be kept “exceptionally low for an extended period.”
Officials have gone beyond that, publicly and privately, to reiterate that intention at every opportunity.
Chicago Federal Reserve Bank President Charles Evans, an FOMC voter in 2009, has said “accommodative policy is likely to continue to be appropriate, I would say, well into 2010 and most likely beyond.”
Bernanke has been more guarded. In his Dec. 3 Senate Banking Committee confirmation hearing, he said “the Fed has a strong commitment to price stability,” but said “jobs are the issue right now.”
To be sure, some officials are more inclined than others to tighten preemptively. But even more hawkish officials have been conspicuously restrained. Dallas Fed President Richard Fisher told me the Fed is watching the dollar’s slide, but said, “unless it becomes disorderly, a depreciating dollar — a gradually depreciating dollar — doesn’t necessarily add an enormous inflation impulse.”
“Inflation is obviously not the issue,” he says. “There is so much excess capacity out there.” Firms are increasing neither hiring nor investing and are unlikely to do so “until they see the whites of the eyes of recovery,” he adds.
Though it is a “lagging indicator,” the expectation that unemployment is going to lag much more than usual, combined with continued tight credit conditions for households and small business, is bound to delay the normalization of interest rates beyond what might otherwise be expected.
Just as tricky as the timing of tightening is the issue of how to tighten. The Fed has continually sought to reassure markets that it has the tools to implement an effective exit strategy, but which tools to use in what sequence is a matter of ongoing debate.
The Fed has two choices: boost the rate of interest it pays on excess reserves and in turn the federal funds rate or to drain reserves.
Some would like to start by hiking the funds rate and believe the Fed’s authority to pay interest on reserves will enable it to effectively increase the funds rate target despite large and growing reserves. Ordinarily, such huge amounts of reserves would be expected to undermine the target. But with interest on reserves, the Fed can incentivize banks to keep holding reserves rather than lending them out.
But while some are confident in the workability of an interest on reserves floor, others aren’t so sure. As Philadelphia Fed President Charles Plosser said, “it would be convenient for all of us if interest rates on reserves operated efficiently enough so that by raising rates on reserves we could prevent all of those excess reserves from flowing out into the economy when the time comes. But I would like to have a Plan B.”
Plan B would be to reduce the amount of reserves, either by outright asset sales or by large reverse repurchase agreements, which could be made semi-permanent through continuous rollovers.
Some officials are adamant that, before it starts to raise rates, the Fed needs to drain reserves. Some would like to start by selling mortgage-backed securities.
Realistically, some combination of these tools seems most likely.
But there is no rush. Until banks begin lending, employers begin hiring and recovery begins looking more self-sustaining, the Fed is going to stand pat.
Steve Beckner is a senior correspondent for Market News International and is regularly heard on NPR. He is the author of “Back from the Brink: The Greenspan Years” (Wiley).