Charles Plosser Speaks On The Fed's "Exit"

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Highlights from the just released speech by Philly Fed hawk Charles Plosser:

  • Fed's Plosser says would want to make explicit the Fed's commitment to a numerical inflation objective
  • Says important to communicate a systemic plan that describes where Fed is going, how it will get there
  • Says his proposed strategy would tie pace of asset sales to size of interest rate increases
  • Says his preferred exit strategy would raise rates, shrink balance sheet concurrently
  • Says failure to exit in timely manner will have serious consequences on inflation, economic stability in future
  • Says monetary policy will have to reverse course in the not too distant future
  • Says consumer spending continues to expand at reasonably robust rate
  • Says US economy seems to be on much firmer foundation
  • Says labor market conditions are improving

In other words, an attempt to return confusion over the fate of QE3. As for the Fed existing anything.... good luck. As part of his exit proposals, Plosser proposes two exit plans (12 and 18 months) both of which sees a dramatic reduction in reserves, a hike in IOER, and asset sell offs. Should the Fed indeed proceed to do this, the market will prolapse.

Full speech:

EXIT

Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia
Shadow Open Market Committee, March 25, 2011, New York, New York

(full pdf)

It is a pleasure to be here today with my old colleagues and friends. I spent the better part of 15 years as a member of the Shadow Open Market Committee External Link
and served as its co-chair with Anna Schwartz for part of that time. It
was a valuable experience and I learned a great deal from our
discussions and debates concerning policy.

When I accepted the position with the Federal Reserve Bank of
Philadelphia in 2006, some of my colleagues thought that I had gone over
to the dark side. I preferred to think of it as trying to help put the
lessons of modern macroeconomics and monetary theory to work in the
making of policy. That has turned out to be easier said than done for a
number of reasons, not the least of which is the onset of the greatest
financial crisis since the Great Depression. Some might think, based on
temporal ordering or a test of Granger causality, that it was my arrival
at the Fed that actually caused the crisis. Yet, we should be cautious
in drawing conclusions about causation from such evidence. Personally, I
prefer to think the crisis occurred despite my arrival at the Fed. But
that is a story for another day.

The financial crisis was, indeed, an extraordinary event, and the
Federal Reserve’s decisions to adopt nontraditional policies in an
attempt to stabilize financial markets and the real economy have taken
it far from the traditional and well-understood operating framework for
conducting monetary policy. Our traditional instrument of monetary
policy — the federal funds rate — has been near zero for more than two
years and is controlled within a range but not precisely. The Fed’s
balance sheet is nearly three times as large as it was before the
crisis, and it is heavily weighted toward long-term Treasuries and
mortgage-related assets.

Although recent global events have created some uncertainties, the
apparent strengthening of the U.S. economy suggests it is prudent for
policymakers to develop a strategy for the normalization of monetary
policy. Today I want to suggest such a strategy. As always, and perhaps
particularly so today, the views I express are my own and do not
necessarily represent those of the Federal Reserve System or my
colleagues on the Federal Open Market Committee.

Economic Outlook

Let me begin by noting that the economy has gained significant
strength and momentum since late last summer and seems to be on a much
firmer foundation going forward. Consumer spending continues to expand
at a reasonably robust pace, and business investment, particularly on
equipment and software, continues to support overall growth. Labor
market conditions are improving. Firms are adding to their payrolls,
which will result in continued modest declines in the unemployment rate.
The residential and commercial real estate sectors remain weak but
appear to have stabilized. Nevertheless, I do not believe that weakness
in these sectors will prevent a broader economic recovery. Indeed, the
nonresidential real estate sector is likely to improve as the overall
economy gains ground.

The tragic events in Japan and the potential for sharply higher oil
prices given the turmoil in the Middle East and North Africa pose some
risk to our recovery. Yet, I believe this risk is small and short term,
assuming Japan is able to stabilize its nuclear reactors and political
unrest in the Middle East does not dramatically disrupt Saudi Arabia,
the region’s largest oil producer.

If this forecast is broadly accurate, then monetary policy will
have to reverse course in the not-too-distant future and begin to remove
the massive amount of accommodation it has supplied to the economy.
Failure to do so in a timely manner could have serious consequences for
inflation and economic stability in the future. To avoid this outcome,
the Fed must confront at least two challenges. The first is selecting
the appropriate time to begin unwinding the accommodation. The second is
how to use the available tools to move monetary policy toward a more
neutral stance over time. Policymakers will have to consider other
important and broader issues as well, including the scope of central
bank responsibilities, the appropriate demarcation between monetary and
fiscal policies, and the moral hazard implications of our nontraditional
actions. But these are not my topic for today, as I have spoken on
these issues elsewhere.1
Nor will I be focusing on the choice of when to begin reversing course.
That, too, is a difficult issue, but not an unusual one.

My focus today will be on the design of an exit strategy. How do we
execute an exit from extraordinary accommodation and nontraditional
policies and move toward a more traditional operating framework for
monetary policy?

The Monetary Policy Operating Framework After Exit

In designing an effective exit strategy, we must start by deciding
what the operating framework should look like at the end of the process.
We must then articulate a systematic approach that will get us to that
framework in a reasonable time frame. The approach must be easily
communicated and thus transparent to the public and the markets, so that
they understand not just where we are headed but how we plan to get
there.

Of course, monetary policy actions should be dependent on economic
conditions, that is, state contingent, and the exit strategy should be
as well. While there is very little economic theory to guide systematic
policymaking using nontraditional tools, we nonetheless should not act
with complete discretion. I have frequently advocated a systematic
approach to policy and our exit strategy should be no different.2 Such a systematic approach reduces uncertainty by offering a degree of commitment by policymakers to the exit strategy.

So where do we want to go? My preferred operating framework for conducting monetary policy in the future has four elements.

First, monetary policy should operate using the federal funds rate
as its policy instrument. Because the Fed can now pay interest on
reserves, monetary policy could use the interest rate on reserves (IOR)
as its instrument, establishing a floor for rates and allow reserves to
be supplied in an elastic manner.3
However, targeting the federal funds rate is more familiar to both the
markets and policymakers than is an administered rate paid on reserves.
To make the funds rate the primary policy instrument, the target federal
funds rate would be set above the rate paid on reserves and below the
discount or primary credit rate that banks pay when they borrow from the
Fed. This operating framework is sometimes referred to as a corridor or
channel system and is used by a number of other central banks around
the world.4
I have argued elsewhere that our goal should be to operate with a
corridor system instead of a floor system, in part because it constrains
the size of the balance sheet while the floor system does not.5

The second element of the environment follows from the first. To
ensure that the funds rate constitutes a viable policy instrument and
thus is above the interest rate on reserves, the volume of reserves in
the banking system must shrink to the point where the demand for
reserves is consistent with the targeted funds rate. This will require a
significant reduction in the size of the Fed’s balance sheet, with
reserve balances falling by $1.4 trillion to $1.5 trillion to about $50
billion.

The third characteristic of my preferred operating environment has
to do with the composition of the Fed’s assets and in particular the
System Open Market Account, or SOMA, portfolio. I believe this portfolio
should consist predominantly of U.S. Treasury securities concentrated
in short-term issues, similar to its composition prior to the crisis. At
that time, about 90 percent of the SOMA assets were Treasuries, of
which about 35 percent were Treasury bills. Currently, only about 60
percent of the portfolio is in Treasuries, while around 40 percent is
housing-related assets, such as mortgage-backed securities (MBS).
Moreover, Treasury bills are less than 2 percent of the Treasury
securities in the portfolio. Thus, the exit plan must contemplate a
significant restructuring of the balance sheet in terms of its
composition and average maturity.

Fourth, my preferred operating environment would make explicit the
Fed’s commitment to a numerical inflation objective, a proposal I have
made many times.6
Numerical inflation objectives are fairly common among major central
banks around the world and many academics and students of central
banking regard adopting such an objective as best practice.7
I believe it is time for the Federal Reserve to adopt this best
practice and clearly announce a numerical inflation objective in support
of our dual mandate. This would be particularly valuable as we exit our
accommodative stance. Since our large balance sheet poses significant
risks for inflation down the road, an explicit commitment to a low and
stable inflation rate would help reassure the public that we will exit
in a way that is consistent with that goal. This would also help keep
expectations of inflation well anchored.

To summarize, my preferred operating environment would re-establish
the federal funds rate as the primary instrument of monetary policy;
shrink the balance sheet and reserves to levels that make the federal
funds rate an effective policy tool; and restructure the balance sheet
in terms of its composition and maturity structure. Adopting an explicit
inflation objective would contribute to the effectiveness of policy and
the policy framework and any plan for normalization.

A Proposed Exit Plan

Now that I have described where I think our policy framework should
be, the next step is to lay out an exit plan that takes us there. As I
argued at the outset, it is important to have a plan. The plan
must be communicated to the public and markets in a way that reduces
uncertainty, and it should explain how decisions will depend on economic
conditions, just like other monetary policy decisions.

Economists have recognized that any exit plan will use several
policy tools, including raising interest rates and shrinking the balance
sheet. Some would start with raising interest rates; some would begin
by shrinking the balance sheet; others would do both.

My proposed strategy involves raising rates and shrinking the
balance sheet concurrently and tying the pace of asset sales to the pace
and size of interest rate increases.8

The first element of the plan to exit and normalize policy would be
to move away from the zero bound and stop the reinvesting program and
allow securities to run off as they mature. Thus, we would raise the
interest paid on reserves from 25 basis points to 50 basis points and
seek to achieve a funds rate of 50 basis points rather than the current
range of 0 to 25 basis points.9
We would also announce that between each FOMC meeting, in addition to
allowing assets to run off as they mature or are prepaid, we would sell
an additional specified amount of assets. These “continuous sales,” plus
the natural run-off, imply that the balance sheet, and thus reserves,
would gradually shrink between each FOMC meeting on an ongoing basis.

The second element of the plan would be to announce that at each
subsequent meeting the FOMC will, as usual, evaluate incoming data to
determine if the interest rate on reserves and the funds rate should
rise or not. Monetary policy should be conditional on the state of the
economy and the outlook. If the funds rate and interest on excess
reserves do not change, the balance sheet would continue to shrink
slowly due to run-off and the continuous sales. On the other hand, if
the FOMC decides to raise rates by 25 basis points, it would
automatically trigger additional asset sales of a specified amount
during the intermeeting period. This approach makes the pace of asset
sales conditional on the state of the economy, just as the Fed’s
interest rate decisions are. If it were necessary to raise the interest
rate target more, say, by 50 basis points, because the economy was
improving faster and inflation expectations were rising, then the pace
of conditional sales would also be doubled during the intermeeting
period.10

The third element of the exit plan must address the composition of
the Fed’s portfolio. If we are to return to an all-Treasuries portfolio,
then asset sales, particularly in the early part of the program, must
be concentrated in MBS.

Examples of the Exit Strategy

What are the consequences of this strategy? In order to make the
proposal concrete, first, let’s assume that excess reserves need to
shrink by about $1.4 to $1.5 trillion in order to permit the federal
funds rate to be reliably above the interest rate paid on reserves.
Second, let’s assume that once asset purchases end and the practice of
reinvesting proceeds from maturing or prepaid assets stops, the balance
sheet will begin to contract by about $20 billion a month, or by about
$30 billion between FOMC meetings, which occur about every six weeks.
This will vary somewhat over time and with the level of interest rates,
but that will make little difference in the overall thrust of the plan.
Third, let’s consider continuous sales of $20 billion in assets between
each FOMC meeting. This pace of continuous sales plus the natural
run-off imply that the balance sheet, and thus reserves, would shrink by
about $50 billion between each FOMC meeting on an ongoing basis.

To illustrate my proposed exit strategy, I want to consider two examples.11
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.12
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.

References

Berentsen, Aleksander, and Cyril Monnet. “Monetary Policy in a Channel System,” Journal of Monetary Economics (2008), 55(6), pp 1067-1080.

Dotsey, Michael. “A Review of Inflation Targeting in Developed Countries,” PDF Federal Reserve Bank of Philadelphia Business Review (Third Quarter 2006).

Kahn, George A. “Monetary Policy Under a Corridor Operating Framework,” PDF External Link Federal Reserve Bank of Kansas City Economic Review (Fourth Quarter 2010).

Martin, Antoine, and Cyril Monnet. “Monetary Policy Implementation Frameworks: A Comparative Analysis," Macroeconomic Dynamics, 15:S1 (forthcoming).

Plosser, Charles. “The Scope and Responsibilities of Monetary Policy,”
speech at the GIC 2011 Global Conference Series: Monetary Policy and
Central Banking in the Post-Crisis Environment, The Central Bank of
Chile, January 17, 2011.

Plosser, Charles. “Credible Commitments and Monetary Policy After the Crisis,” speech to the Swiss National Bank Monetary Policy Conference, September 24, 2010.

Plosser, Charles. “Sound Monetary Policy for Good Times and Bad,” speech to Merk Investments/Stanford SIEPR Panel, Stanford University, October 20, 2009b.

Plosser, Charles. “Ensuring Sound Monetary Policy in the Aftermath of Crisis,” speech to the U.S. Monetary Policy Forum, University of Chicago Booth School of Business, February 27, 2009c.

Plosser, Charles. “The Benefits of Systematic Monetary Policy,” speech to The National Association for Business Economics, Washington Economic Policy Conference, March 3, 2008.

Taylor, John. “An Exit Rule for Monetary Policy,” a paper
originally prepared for the House Committee on Financial Services
hearings on “Unwinding Emergency Federal Reserve Liquidity Programs and
Implications for Economic Recovery,” February 10, 2010. (Also published
as Discussion Paper 09-009 by the Stanford Institute for Economic Policy
Research and available at http://www-siepr.stanford.edu/repec/sip/09-009.pdf). PDF External Link

  • 1 See Plosser (2011), (2010), (2009a), (2009b).
  • 2 See Plosser (2008), (2009a), (2010).
  • 3
    It is possible to distinguish the interest rate paid on required
    reserves from the rate paid on excess reserves, but we can ignore that
    complication for my purposes here.
  • 4
    Other central banks implementing a corridor or channel system include
    the Bank of Canada, Bank of England, Bank of Japan, European Central
    Bank, Norges Bank, Reserve Bank of Australia, Reserve Bank of New
    Zealand, and the Swedish Riksbank. In the recent financial crisis, the
    ECB, Bank of Japan, Bank of England, Bank of Canada, and Norges Bank
    have moved to floor systems due to the expansion of their balance
    sheets. See Berentsen and Monnet (2008), Kahn (2010), and Antoine and
    Monnet (2011).
  • 5 See Plosser (2010a).
  • 6 See Plosser (2009a), (2009b), (2008).
  • 7
    Inflation targets have been adopted by numerous economic regimes,
    including Australia, England, Brazil, Canada, Chile, the Czech Republic,
    the European Central Bank, Hungary, Indonesia, Israel, Korea, Mexico,
    New Zealand, Norway, the Philippines, Poland, South Africa, Sweden, and
    Thailand. See Dotsey (2006).
  • 8 Taylor (2010) also suggests linking sales to interest rate decisions.
  • 9
    This may be difficult to achieve in the short term due to technical
    challenges, but we would learn about the challenges of hitting a target
    under a floor system.
  • 10
    This assumes a linear relationship between the size of the policy rate
    increase and the volume of sales. We could consider a nonlinear
    relationship, whereby doubling the size of the rate increase would
    entail less than a doubling in the volume of sales, but a drawback would
    be that we would not regain control over the funds rate target as an
    independent policy instrument until interest rates were at a higher
    level.
  • 11 See the Table.
  • 12 See the Table.
Exit Strategy Example 1: Normalization in 12 Months
 
FOMC MEETING
0
1
2
3
4
5
6
7
8
9
Funds Rate/IOR
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.50
Change in
Funds Rate/IOR
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0
Beginning of Period Total Reserves ($ bil.)
$1,500
$1,450
$1,275
$1,100
$925
$750
$575
$400
$225
$50
Asset Run-off ($ bil.)
$30
$30
$30
$30
$30
$30
$30
$30
$30
$0
Continuing Asset Sales ($ bil.)
$20
$20
$20
$20
$20
$20
$20
$20
$20
$0
Conditional Asset Sales ($ bil.)
$0
$125
$125
$125
$125
$125
$125
$125
$125
$0
Exit Strategy Example 2: Normalization in 18 Months
 
FOMC MEETING
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Funds Rate/IOR
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.50
2.75
3.00
3.25
3.50
Change in
Funds Rate/IOR
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0.25
0
Beginning of Period Total Reserves ($ bil.)
$1,500
$1,450
$1,333
$1,216
$1,099
$982
$865
$748
$631
$514
$397
$280
$163
$46
Asset Run-off ($ bil.)
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$30
$0
Continuing Asset Sales ($ bil.)
$20
$20
$20
$20
$20
$20
$20
$20
$20
$20
$20
$20
$20
$0
Conditional Asset Sales ($ bil.)
$0
$67
$67
$67
$67
$67
$67
$67
$67
$67
$67
$67
$67
$0