–Stresses Need To Anchor Inflation Expectations at 2%
By Steven K. Beckner
(MaceNews) – New York Federal Reserve Bank President John Williams defended the Fed’s 2% average inflation target Friday, while emphasizing the need to solidify expectations around that rate.
Williams, vice chairman of the Fed’s policymaking Federal Open Market Committee, acknowledged that the real short-term equilibrium interest rate (r*) and in turn the “neutral” federal funds rate has fallen by roughly 200 basis points over the past decade or so and that this has made monetary policy more vulnerable to reaching the zero lower bound for the funds rate.
But Williams, who pioneered research into r* as a Federal Reserve Board economist, resisted calls for increasing the inflation target to lessen that vulnerability during a webinar hosted by the Bank of France.
His comments came days after the Labor Department reported that is consumer price index rose at a 5.4% year-over-year rate in September – more than twice the Fed’s “price stability” objective.
Williams did not comment on current monetary policy issues just over two weeks before the FOMC again considers whether to scale back its $120 billion monthly asset purchases. All indications are that the FOMC will announce a tapering of bond buying, while keeping the federal funds rate in a target range of zero to 25 basis points.
Some economists, including former senior Fed Board staffers David Wilcox and David Reifschneider, have urged the Fed to raise the inflation target to 3% to make it easier for the Fed to avoid the constraints of the zero lower bound.
But Williams made clear he doesn’t think that’s a good idea. He said he and his fellow policymakers arrived at an average 2% inflation target when doing their “framework review” last year and said, “the framework positions us well.”
“The cost of raising the inflation target by a sizable amount is that you’re basically taking the cost of higher inflation all the time,” he said, adding that “2% is very consistent with … people not being worried about medium or long term inflation being too high or low.”
Williams stressed that sustaining a 2% inflation rate on average is “really about anchoring inflation expectations at 2%.”
“We really focused in our framework review on doing that.”
Williams said the fall in r* and the neutral rate has been a global phenomenon that has international implications, including heightened “spillovers” between the United States and other countries, who once thought they were immune to the zero lower bound for short-term interest rates.
But he said the Fed and other central banks face a “great deal of uncertainty” in trying to estimate r* and other variables used in economic models such as the so-called Taylor Rule which central bankers use to set monetary policy. He said the Fed needs to constantly assess r* and other “stars” and compare them to how the economy is actually behaving.
The day before Williams’ comments, his executive vice president Lorie Logan said the implementation of monetary policy, which she supervises at the New York Fed, is going well, despite record expansion of the Fed’s balance sheet and record drawdowns from the Overnight Reverse Repurchase (ON RR) facility she administers.
From March to December 2020, the Fed’s assets increased by roughly $3 trillion, accompanied by a commensurate increase in Federal Reserve liabilities in the form of bank reserves. But Logan said growth in the U.S. Treasury’s General Account (TGA) “limited reserve growth associated with the balance sheet expansion.”
Since mid-2020, the pace of net asset purchases slowed, as the FOMC limited purchases to $120 billion per month, but Logan noted that “even with this more steady pace of balance sheet growth, Federal Reserve liabilities held by market participants – in the form of reserves and ON RRP balances – increased sharply in 2021.”
“This resulted from the dramatic $1.5 trillion decline in the TGA since the beginning of the year,” she explained.
As asset purchases pushed down market rates and bank deposit rates, people moved into money market funds, while at the same time the net supply of U.S. Treasury bills available to those funds fell by over $1.2 trillion so far in 2021.”
Because the combination of increased liquidity and reduced supply of investment options threatened “to put substantial further downward pressure” on the federal funds rate, she said the Fed established the overnight reverse repurchase facility.
The ON RRP facility, in which money market funds and other firms earn interest at the Fed by purchasing a bond from the New York Fed open market desk and selling it back at a lower price, is helping to “support interest rate control,” Logan said.
“In the first quarter of this year, ON RRP facility usage became more regular, and it has increased rapidly since,” she continued. “Recently, reductions in the TGA and Treasury bill supply have accelerated, and the ON RRP facility has exceeded $1.2 trillion consistently since mid-September.”
Some observers have been alarmed at the increased usage of ON RRP, but Logan said it is “working as intended, even as usage expands to new highs.”
“Just as IORB (interest on reserve balances) creates a floor for rates on bank lending activity, the ON RRP facility supports control of the federal funds rate by providing a soft floor for the overnight money market activity of a broader set of money market participants,” she elaborated.
“Usage of the facility also broadens the holders of Federal Reserve liabilities beyond banks, easing pressure on bank balance sheets that may result from reserve growth,” she added.
Logan noted that “the supply of reserves has increased relatively modestly this year, as the ON RRP facility absorbed much of the increase in liquidity from the decline in the TGA and ongoing asset purchases.”
She went on to extol the benefits and flexibility of the ON RRP facility. “An essential feature of the ON RRP facility is that it has a fixed rate and therefore its size is determined by the interest rate environment.”
“Just as usage of the facility grew in response to downward pressure on money market rates, it should decline in response to increases in them,” she continued. “For example, if Treasury were to expand Treasury bill supply and interest rates on these instruments rose above the ON RRP rate, investors should naturally reallocate out of the facility and back into these assets. Similarly, if the supply of reserves declines and rates rise relative to the IORB rate, ON RRP balances should naturally recede.”
Logan said “the flexible size of the ON RRP facility helps the FOMC’s ample reserves framework adapt smoothly to different reserve and money market environments.”
Contact this reporter: steve@macenews.com
Content may appear first or exclusively on the Mace News premium service. For real-time delivery contact tony@macenews.com. Twitter headlines @macenewsmacro.