– ‘Time Has Come’ To Transition to More ‘Normal’ Monetary Stance
– Urges FOMC Should ‘Take First Step’ to Tighten Monetary Policy
– FOMC Could Raise Rates First, but Must Start to Shrink Balance Sheet
By Steven K. Beckner
(MaceNews) – Kansas City Federal Reserve Bank President Esther George asserted the need Tuesday for a determined shift to a more “normal,” less stimulative monetary policy to combat high inflation.
George, who will be voting this year on the Fed’s policy-making Federal Open Market Committee, acknowledged continued adverse Covid effects on the economy, but nevertheless said, “the time has come to transition monetary policy away from its current crisis stance towards a more normal posture in the interest of long-run stability.
In particular, she suggested the Fed needs to start shrinking its balance sheet much sooner than it did after it concluded “quantitative easing” in October 2014 – three years in that case. She was vague about the timing or pace but urged the FOMC to start communicating soon about when and how it will shrink the balance sheet in conjunction with rate hikes.
Rate hikes could come before QT (quantitative tightening), as in the past, but shrinking the $8.8 trillion Fed bond portfolio must be addressed before long, she stressed, saying the important thing is to “take the first step.”
“With robust demand, high inflation, and a tight labor market, policy-makers will need to grapple with the appropriate speed and magnitude of adjustments across multiple policy tools as they work to achieve their long-run objectives for employment and price stability,” she told the Kansas City Central Exchange, a group of business women, in prepared remarks.
George warned “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.”
Faced with the worst inflation in 40 years, the FOMC shifted to a more aggressive monetary tightening posture at its Dec. 14-15 meeting. It quickened the pace at which it is winding down asset purchases, setting the stage for increases in the federal funds rate from near zero as early as March.
FOMC participants projected at least three rate hikes in 2022. Financial markets are expecting four moves.
George did not dispute the FOMC action, but suggested more is needed, though she did not lay out a clear timetable, either for funds rate hikes or balance sheet reduction.
“We’re already facing a situation where inflation is well beyond the stated target, where labor markets, even though still millions of workers haven’t returned .., are very tight …with wages rising …,” she said when asked about how the Fed needs to respond to high inflation. “We need to begin the process of making those necessary adjustments.”
George was intentionally vague about the timing and pace of balance sheet reductions and rate hikes when asked whether she supports a Fed colleague’s proposal to begin shrinking the balance sheet by $100 billion per month about without any “ramp-up period.” She put more emphasis on preparing the public and the markets for tightening.
“For me, my real focus is on beginning the important communication that has to accompany the Federal Reserve beginning to withdraw accommodation,” she said. “Right now, the signal has come, which is, we will begin to back off of accommodation, but of course we are still adding each month to the balance sheet.”
“So, I support that effort to communicate and say, yes, we’re going to begin to pull back, but I think increasingly as we look at the outlook for the economy, as we just look at where we are today, monetary policy needs to take that first step to begin to adjust that policy …,” she continued.
George noted that, at the start of the last tightening cycle in 2014-15, the Fed began by incrementally raising the funds rate, and she said, “that could be the sequence we do again .…”
However, she emphasized, “I don’t think we can ignore the fact that we have an extraordinarily large balance sheet this time, and so I think we’re going to have to think about both of those instruments – both the interest rates as well as the balance sheet.”
“So, I look forward to that deliberation with my colleagues – about how we do that, how we communicate that to the public, so that people will understand we’re in the process of normalizing and here is how it’s likely to take shape,” she went on.
“Those decisions have not yet been made, but as I say, I think it’s time for us to really talk about that in earnest,” she added.
George contended in her prepared remarks that the Fed‘s current ultra-low rate posture is not only inconsistent with economic conditions but unhealthy for financial markets.
The Fed is “currently providing a historic amount of accommodation to the economy,” she said, noting that real short-term interest rates “are near record lows” and that the doubling of the Fed’s bond portfolio has held down long-term rates and has “push(ed) investors to look for alternative and perhaps riskier investments.”
“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 continued.
“Even after accounting for the FOMC’s decision at its December meeting to accelerate the timeline for ending asset purchases, the balance sheet will grow further until March,” she added.
George conceded “removing accommodation will unavoidably be complicated by the use of multiple policy instruments.” She said she and her fellow policy-makers will have to “consider the interaction between the ultimate size of the balance sheet and the longer-run normal funds rate.”
“All else equal, maintaining a large balance sheet could imply a higher short-term interest rate to offset the stimulative effect of the balance sheet’s continued downward pressure on longer-term interest rates,” she said.
A former top bank supervisor known for her sensitivity to financial stability threats, George suggested it makes no sense to raise rates “while maintaining an outsized balance sheet,” because doing so “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 her “own preference would be to opt for running down the balance
sheet earlier rather than later as we plot a path for removing monetary accommodation.”
In the 2014-2017 period, George recalled “the FOMC delayed adjusting the size of the balance
sheet until the normalization of the funds rate was ‘well under way’” in order to “offset any unexpected turbulence.”
But, as Fed Chairman Jerome Powell and others have also suggested, George said “this rationale seems less compelling now, and …. discounts the yield curve implications of moving the funds rate higher while maintaining a large balance sheet.”
“All in all, I believe that it will be appropriate to move earlier on the balance sheet relative to the last tightening cycle,” she said.