I will reiterate a question I raised yesterday, as perhaps it was buried too deep in the Bits Bucket: Does the Fed really ever need to exit from all the asset purchases it has recently made, or can it simply keep them forever entombed on its balance sheet, similar to the fate of poor Fortunato in The Cask of Amontillado?
What future course of events could or would force a Fexit?
P.S. I was happy to discover language in Plosser’s speech questioning the wisdom in using monetary policy to preferentially support the mortgage market. So far it seems as though MSM writers have missed this point.
Speeches
Economic Outlook and Monetary Policy
Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia
CFA Society of Philadelphia/The Bond Club of Philadelphia, September 25, 2012
Introduction
Let me welcome you all to the Federal Reserve Bank of Philadelphia and to thank both the CFA Society and the Bond Club for inviting me to speak today. In October of 2006, I gave my first speech as president of the Federal Reserve Bank of Philadelphia to the CFA Society of Philadelphia. Well, a lot has happened since then, and the world is a different place. So I will use my time with you today to offer my perspective on the current state of the economy and monetary policy.
…
Before continuing, I should note that my views are my own and not necessarily those of the Federal Reserve Board or my colleagues on the FOMC.
…
Monetary Policy
Let me now turn to some thoughts on monetary policy. Even before the actions taken this month, the Fed had put into place an extraordinary amount of accommodation to support the recovery. The Fed has kept the federal funds rate near zero for more than 45 months; it has completed two rounds of asset purchases that more than tripled the size of the Fed’s balance sheet; and it is implementing a maturity extension program, known as “operation twist,” which is lengthening the maturity of our holdings of Treasury securities. These actions have changed the composition of the portfolio from mainly short-term Treasuries before the crisis to mostly longer-term Treasuries and housing-related securities today.
Many of these actions were taken at the height of the financial crisis and during the ensuing deep recession. But the financial crisis has substantially abated and the economy has been healing, if somewhat more slowly than we would like. In fact, if you compare today’s economic and financial conditions to the conditions that prevailed when the FOMC previously took bold actions, you will see that the economy is undoubtedly in a better position.
At its latest meeting in September, the FOMC decided to begin a third round of quantitative easing, commonly known as QE3, with the purchase of additional agency mortgage-backed securities at a pace of $40 billion per month. The FOMC statement indicated that if the outlook for the labor market does not improve substantially, the Fed would make these purchases and more and would employ other policy tools as appropriate until such improvement is achieved within a context of price stability. I interpret “within a context of price stability” to mean so long as the inflation outlook remains near the Committee’s goal of 2 percent. The FOMC statement also said that the Committee expects a highly accommodative stance of monetary policy to remain appropriate for a considerable period after the economic recovery strengthens. It also stated that the Committee currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
The Committee’s decision was based on the view that with unemployment far above the level typically seen in normal times and inflation near its goal, increasing the amount of monetary accommodation should help bring unemployment down without jeopardizing our inflation goal. And since the Fed said it expects to keep substantial accommodation in place even after the recovery strengthens, people and businesses should be reassured that the recovery will remain intact, even in the face of future adverse shocks. This should make households and firms comfortable spending more today rather than saving, which should, in turn, spur hiring.
I opposed the Committee’s actions in September because I believe that increasing monetary policy accommodation is neither appropriate nor likely to be effective in the current environment. Every monetary policy action has costs and benefits, and my assessment is that the potential costs and risks associated with these actions outweigh the potential meager benefits.
Given the magnitude and nature of the shocks that hit our economy, one should not be particularly surprised by the slow recovery. Both the housing and the financial sectors suffered large declines, and it will take time for the economy to adjust. While unemployment is expected to remain above FOMC participants’ range of estimates of its longer-run level for some time, it is not at all clear that monetary policy can speed up that transition. In other words, the slow pace of the recovery should not be taken as evidence that the stance of monetary policy is inappropriate or that ever more aggressive accommodation can speed up that pace.
Indeed, many economists expect that further asset purchases by the Fed are unlikely to reduce long-term interest rates by a significant amount; some studies suggest that the effect will be quite small and transitory. Given our current economic situation and my reading of the empirical evidence, I do not believe that lowering interest rates by a few more basis points will spur further growth or higher employment. Business leaders who have talked to me continue to cite uncertainty about fiscal decisions — here and abroad — as the greatest hindrance to hiring and investment. Hopefully these uncertainties will abate over time, but the central bank can do little to alleviate them.
And as far as households are concerned, they continue to try to repair their balance sheets in the wake of substantial losses of housing wealth, as I indicated earlier. They are deleveraging and saving more. It seems unlikely that a small drop in interest rates will overturn the strong desire to save and, instead, induce households to spend more. In fact, driving down interest rates even further may encourage consumers to save even more to make up for lower returns.
Thus, in my view, we are unlikely to see much benefit to growth or to employment from further asset purchases. If I am right, then conveying the idea that such action will have a substantive impact on labor markets and the speed of the recovery risks the Fed’s credibility. This is quite costly: If the public loses confidence in the central bank, our ability to set effective monetary policy in the future will be harmed and households and businesses will feel the consequences.
The recent actions risk the Fed’s credibility in other ways as well. The rationale for the actions leading to increased spending today depends on the Fed’s ability to convince the public that it will conduct policy in a fundamentally different way than it has in the past. People must believe that we will delay raising interest rates compared to when we normally would and, by so doing, make the economy stronger than it otherwise would be. At the same time, people must believe that we will ensure that inflation expectations do not take off and threaten longer-run price stability. Making such a change in the policy regime believable will be very hard to do. If the public doesn’t believe that we will delay raising rates, they won’t bring spending forward and the policy will be ineffective. But if they do believe we will delay raising rates, they may infer that the Fed is willing to tolerate considerably higher inflation. This may spur an increase in inflation expectations, which would require a response from the FOMC, or else risk the credibility of its commitment to keep inflation low and stable. I do not think it prudent to risk that hard-won credibility. The subtlety and complexity of successfully managing expectations in this manner make this quite a risky policy strategy in my view, with little evidence of quantitatively meaningful results for employment.
Continued expansion of the Fed’s balance sheet has other costs as well. By greatly expanding the size of the Fed’s balance sheet, the new asset-purchase program will exacerbate the challenges that the Fed will face when it comes time to exit this period of extraordinary accommodation, risking higher inflation and harm to the Fed’s reputation and credibility. I have been a student of monetary theory and policy for over 30 years. One constant is that central banks tend to find it easier to lower interest rates than to raise them. Moreover, identifying turning points is difficult even in the best of times, so timing the change in the direction of policy is always a challenge. But this time, exit will be even more complicated and risky. With such a large balance sheet, our transition from very accommodative policies to less accommodative policies will involve using tools we have not used before, such as the interest rate on reserves, term deposits, and asset sales. Once the recovery takes off, long rates will begin to rise and banks will begin lending the large volume of excess reserves sitting in their accounts at the Fed. This loan growth can be quite rapid, as was true after the banking crisis in the 1930s, and there is some risk that the Fed will need to withdraw accommodation very aggressively in order to contain inflation. At this point, it is impossible to know whether such asset sales will be disruptive to the market. A rapid tightening of monetary policy may also entail political risks for the Fed. We would likely be selling the longer maturity assets in our portfolio at a loss, meaning that we may be unable to make any remittances to the U.S. Treasury for some years. Yet, if we don’t tighten quickly enough, we could find ourselves far behind the curve in restraining inflation.
While these risks are very hard to quantify, it is clear that the larger the Fed’s portfolio becomes, the higher the risk and the potential costs when it comes time to exit. And based on my economic outlook, that time may come well before mid-2015. In my view, to keep the funds rate at zero that long would risk destabilizing inflation expectations and lead to an unwanted increase in inflation. In fact, some are interpreting the FOMC’s statement that we will keep accommodation in place for a considerable time after the recovery strengthens as an indication that the Fed is focused on trying to lower the unemployment rate and is willing to tolerate higher inflation to do so. This is another risk to the hard-won credibility the institution has built up over many years, which, if lost, will undermine economic stability.
Some of my colleagues on the FOMC have advocated giving quantitative triggers or thresholds for the level of unemployment and inflation to explain the economic conditions that would lead the Fed to consider a change in policy stance. For example, the Fed might indicate that extraordinary accommodation would remain in place if unemployment were above, say, X percent, so long as its outlook for medium-run inflation was not higher than, say, Y percent.
I believe that policy should be state-contingent and systematic, and that the FOMC should strive to explain its policy reaction function — how it expects to change policy as economic conditions change. A Taylor rule is one such reaction function, but research indicates that other simple rules are good guides to policy even when the true model of the economy is uncertain. These rules involve policy responding aggressively to deviations of inflation from its target and also responding to deviations of output from some concept of its potential. In addition, the rules tend to involve some smoothing of the policy rate over time rather than sharp jumps in rates. Using such robust rules as guides to policy is, in my view, the appropriate way to communicate policy guidance. As a result, as many of you know, I have never been an advocate of calendar-date forward guidance. I thought it was a mistake when we implemented that language, and it remains a nettlesome communication problem.
But while the unemployment-inflation thresholds do move away from calendar-date guidance and toward economic conditions, they fall short of a reaction function that I would like to see, since they say nothing about how monetary policy will change after such levels are reached. Will the FOMC tighten quickly? Or slowly? How will the Committee decide? In addition, the unemployment rate is not the only factor to consider in judging the state of labor markets. Indeed, it fell two-tenths of a percentage point in August, yet few think that represented improved labor market conditions. The reduction stemmed from a decrease in the participation rate rather than an increase in employment. In addition, I am not convinced that the inflation trigger would prove to be much of a constraint. While the unemployment trigger is based on the current value, the inflation trigger is based on the outlook for inflation, and if monetary policy is being set appropriately, this outlook should be consistent with price stability. Thus, I believe that using thresholds or triggers could easily put us behind the curve, if we have a tendency to underestimate future inflation.
Finally, I also opposed September’s decision to purchase additional mortgage-backed securities. In general, central banks should refrain from preferential support for one sector or industry over another. Those types of credit-allocation decisions rightfully belong to the fiscal authorities, not the central bank. Engaging in such actions endangers our independence and the effectiveness of monetary policy.
…
No comments:
Post a Comment