- Funds Rate ‘Far Away’ From ‘Normal’
- Monetary Policy ‘Out of Sync’ With Economic Outlook
By Steven K. Beckner
(MaceNews) – Kansas City Federal Reserve Bank President Esther George said Monday that the Fed needs to move “deliberately” to withdraw the unprecedented monetary stimulus adopted to counter the Covid lockdown-induced recession.
George, who is voting this year on the Fed’s policy making Federal Open Market Committee, said monetary policy is “out of sync” with the economic outlook and needs to “transition” toward a more “normal” policy stance, given that the federal funds rate is “far away” from any semblance of “normal.”
The FOMC may not have the luxury of moving as “gradually” as it might like, she suggested.
Aside from raising short-term interest rates, it “could be appropriate” to start shrinking the Fed’s balance sheet much sooner than it did the last time the Fed was unwinding quantitative easing, she told the Economic Club of Indiana.
At its first meeting of the year last week, the FOMC left the funds rate in a zero to 25 basis point target range, but signaled it will start raising that key short-term interest rate at its mid-March meeting.
“With inflation well above 2% and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate,” the FOMC said in its policy statement, and Chairman Jerome Powell late said, “the committee is of a mind to raise the federal funds rate at the March meeting assuming that conditions are appropriate for doing so.”
FOMC participants projected three 2022 rate hikes in December, but many now expect more. Powell seemed to leave the door open to more aggressive action when asked whether the FOMC would be raising rates at every meeting, telling reporters, “We know that the economy is in a very different place than it was when we began raising rates in 2015.”
“Specifically, the economy is now much stronger, the labor market is far stronger, inflation is running well above our 2% target, much higher than it was at that time and these differences are likely to have important implications for the appropriate pace of policy adjustments,” Powell continued.
Powell, who stressed the need to be “humble and nimble” given risks of “more persistent” wage-price pressures, went on to say “there’s quite a bit of room to raise interest rates without threatening the labor market.”
The FOMC also said it will end its asset purchases “in early March” and released a broad set “principles” for “significantly reducing the size of the Federal Reserve’s balance sheet.” Powell said the FOMC can do so “sooner and faster” than in 2014, when the FOMC waited three years after ending quantitative easing before it began quantitative tightening.
Many Fed watchers now think the Fed will start shrinking its massive bond portfolio by mid-year.
George hedged when asked whether the FOMC will raise rates “gradually” or more rapidly. Some have suggested it should start with a 50 basis point hike in the funds rate.
George was deliberately vague, but suggested the FOMC may not be able to raise the funds rate as “gradually” as it might like. Her preferred adverb was “deliberately.”
“This question is coming up, of course, because when you look at the distance from zero interest rates to whatever number you think might be normal – 2 to 2 ½% ..we’re a long way,” she observed. “And we’re faced today with high inflation. We haven’t seen inflation at 7% since 1982, when I started at the Federal Reserve.”
“So it puts pressure (on the Fed) to say ‘now is the time to remove that’ (accommodation),” she continued.
“And whether it’s removing it quickly, I think the message is we’re going to start that process,” George went on. “And, of course, we have to think carefully about the lags that come with those policy decisions. We have to think about what other changes are going on in the economy that may affect its growth and those variables that we look at.”
“So ideally you always want to go gradually in the economy because it’s in in one’s interest to try to upset the economy with unexpected adjustments,” she added. “But I do think the Federal Reserve is going to have to move deliberately in its decisions and that was signaled at our last meeting.”
George, who has been an advocate for early normalization of monetary policy, was emphatic about the need to withdraw monetary accommodation in her prepared remarks.
“With inflation running at close to a 40-year high, considerable momentum in demand growth, and abundant signs and reports of labor market tightness, the current very
accommodative stance of monetary policy is out of sync with the economic outlook,” she said.
Accordingly, she said, the FOMC last Wednesday “acknowledged the need to shift its policy settings with interest rate increases and significant reductions in asset holdings on the horizon.”
Taking note of the balance sheet reduction principles published by the FOMC, George said they are “just a start, and a number of important and difficult decisions remain.”
“In particular, I expect it will be important to consider the interaction between reductions in the size of the balance sheet and increases in the policy rate,” she continued.
George said there may well be trade-offs between rate hikes and balance sheet reduction. “For example, more aggressive action on the balance sheet could allow for a shallower path for the policy rate.”
“Alternatively, combining a relatively steep path of rate increases with relatively modes reductions in the balance sheet could flatten the yield curve and distort incentives for private
sector intermediation, especially for community banks, or risk greater economic and financial fragility by prompting reach-for-yield behavior from long-duration investors,” she said.
George reiterated her desire to move faster on balance sheet reduction than in the 2014-17 period.
“In the previous normalization cycle, the FOMC delayed adjusting the size of the balance sheet until the normalization of the funds rate was ‘well under way,’” she recalled. “The rationale for this timing was predicated on the novelty of balance sheet normalization and the desire for space to offset any unexpected turbulence.”
Now, however, George said moving slowly “discounts the yield curve implications of moving the funds rate higher while maintaining a large balance sheet.”
“All in all, it could be appropriate to move earlier on the balance sheet relative to the last tightening cycle,” she added.
Looking toward the ultimate size of the balance sheet, which has doubled since the onset of the pandemic, George warned against leaving it too large.
“While it might be tempting to err on the side of caution, the potential costs associated with an excessively large balance sheet should not be ignored,” she said.
One cost cited by George is “ the distortive effects of the size of the Fed’s balance sheet on the financial system. A large Fed presence in markets can displace private activity, even in a market as large and liquid as that for U.S. Treasuries and certainly where the central bank holds roughly 1/4 of the MBS market.”
“This presence can distort price signals, currently most evident in the pricing of duration,” she elaborated. “By holding long duration assets, the Fed’s balance sheet is depressing the price of duration, by lowering longer-term yields by as much as 1.5 percentage points according to some rules-of-thumb, incentivizing reach-for-yield behavior and increasing fragility within the financial system.”
“As we purchased assets, our goal was in part to artificially depress term premia, pushing down long-run rates and supporting economic activity,” she went on. “In normalizing our balance sheet, we should aim to eliminate this distortion.”
A second cost of keeping the balance too large, according to Geroge is that it “reduces available policy space in the inevitable next downturn. With the zero lower bound likely to bind for short-term rates, the trend decline in long-term rates has also decreased the amount of policy space we have at the longer end of the curve.”
“Just as increases in the policy rate provide us with space to cut short term rates, decreasing the size of our balance sheet, and increasing term premia, could provide space to push down long-run yields in the next downturn.”
The third cost George cited is that “a large balance sheet has the potential to intertwine fiscal and monetary policy in the public’s eyes and could unintentionally pose risks to the Fed’s independence and authority.”
“In a rising rate environment, this risk could become more apparent as interest paid on the large stock of reserve liabilities grows,” she added.
Because of these potential costs, George said the Fed is “likely to face a different set of challenges and consequential decisions than we did with our previous experience with balance sheet adjustments.”
George pointed out that, in contrast to the last QT, “the current balance sheet is historically large relative to the size of the economy, and the economy itself is in a far different place.”
“In 2015, inflation was well below 1 percent; the unemployment rate was 5 percent; and the economy was growing just under 2 percent annually. The balance sheet was half the size it is today,” she recalled. “The starting point for policy adjustments in 2022 stands in stark contrast to the 2015 experience with high inflation, tight labor markets, a robust demand outlook, and elevated asset valuations.”
George acknowledged that the pandemic “continues to influence economic activity,” but said “monetary policy is transitioning away from its current crisis stance towards a more neutral posture in the interest of meeting its long-run objectives.”
It wont’ be easy she admitted.
“Policymakers will need to grapple with the appropriate pace and size of adjustments across multiple policy tools in the context of a changing and challenging environment,” George said. “That transition could be a bumpy one, with the prospect of asset valuation adjustments and the recalibration of supply and demand towards a new equilibrium.”
Contact this reporter: steve@macenews.com
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