The employment and growth data in the US is sufficient for the Federal Reserve to begin reducing its asset-purchase programme, and end the printing of money by the end of the year.
So argues Charles Plosser, president and CEO of the Federal Reserve Bank of Philadelphia and one of the members of the Federal Open Market Committee (FOMC), who spoke last night in Hong Kong at a seminar organised by MNI, a financial news agency owned by Deutsche Boerse.
“There’s plenty of shrinking to be done,” of the Fed’s balance sheet, he said, noting that current reserves total $1.8 trillion and growing, versus only $25 billion before the onset of the financial crisis in 2008. The balance sheet now includes $3.2 trillion of assets and is expanding by $85 billion per month.
For now, Plosser’s view remains in the minority on the FOMC and the Federal Reserve Board of Governors. But the leaked minutes of the latest FOMC meeting reveals a growing unease with quantitative easing and the distortions and potential volatility it creates.
For the scales to tip in Plosser’s favour will require steady gains in employment figures and growth in the US economy. The March employment report disappointed, showing only 95,000 jobs added to the economy, but Plosser argues that such figures are volatile, fluctuate month to month, are usually revised upwards and ignore the generally improving trend.
Some technical work needs to be done as well before the Fed is likely to begin exiting its QE strategy. First, Plosser calls for the Fed to normalise the spread between the Fed’s discount rate on overnight loans to financial institutions, and the funds rate target. During the crisis, the Fed reduced this spread from 100bp to 25bp to encourage banks to borrow from the Fed’s discount window. The lending rate was subsequently raised to 50bp, and Plosser says it should return to its pre-crisis rate. This would normalise the price of money for the banking system.
Secondly, Plosser calls for the Fed to rethink how it reinvests the assets in its portfolio. Thanks to Operation Twist, the Fed no longer holds any short-term Treasuries. Currently it reinvests its longer-dated securities, but Plosser says it should reinvest in shorter-term assets to provide the Fed with more flexibility.
Once those moves are made, the Fed will be able to plot an exit strategy. Plosser suggests this should involve restoring the federal funds rate as the central bank’s primary policy instrument, allowing it to operate within a band set between interest paid on reserves and the primary credit rate (the discount rate for banks).
In other words, he is calling for the restoration of interest rates as the mechanism by which the Fed transmits signals to the markets, rather than printing money.
This can come about by shrinking the balance sheet to pre-crisis levels, and changing the composition of the portfolio to short-duration instruments.
Plosser says this would initially involve ceasing to reinvest some or all of the payments of principal on the Fed’s securities holdings, and then gradually raise the target Fed funds rate by adjusting the interest rate on reserves. The next step would be to start selling the Fed’s portfolio of agency securities, particularly its mortgage-backed securities.
Plosser acknowledges that this involves risks. No one knows at what pace these measures should be executed, nor what Fed funds rate to target. Asset sales could cause markets to push up interest rates faster than the Fed expects, putting the recovery in danger.
There is also the danger that inflation gets out of control, as all of those assets are monetised in the banking system. The Fed’s credibility is at stake if it backtracks from any path it champions. And Plosser admits he doesn’t know what the effect of an exit would be on longer-term Treasury yields.
However, Plosser believes the costs of inaction are greater. If asset purchases continue at current levels, reserve balances could grow to $2.25 trillion or more. The bigger the portfolio, the faster the Fed may have to sell them at some point, increasing the likelihood of selling at a loss. That would bring unwelcome public scrutiny of the Fed at a time when the national mood is focused on cutting the budget deficit.
The second problem with delaying action is the continuing distortions that QE creates, particularly the manner in which it is forcing pension funds and insurance companies to turn to greater duration and interest-rate risk.
“The complexity of shrinking the balance sheet is nuanced,” Plosser says. “We are in uncharted territory.”
He expects US economic growth will be around 3% this year and next. He also projects US unemployment to decline to 7% this year and possibly 6.5% next year, while the outlook for inflation remains stable.
“Eventually, economic conditions will improve to the point at which the Fed will need to begin to exit from this period of extraordinary accommodation and normalise its framework for monetary policy,” Plosser says. And that means the Fed must first stop expanding its balance sheet, before it gets to a size that makes it even more difficult to allow for a smooth return to normalcy.