As the Federal Reserve begins to wind down an accommodative monetary policy, it might consider a gradual reduction in its balance sheet, Federal Reserve Bank of Boston President Eric Rosengren said this week.
In a speech at the Central Bank of Guatemala, Rosengren said that that large-scale asset purchases, forward guidance and the Fed’s maturity extension program contributed to lower marketplace interest rates, a faster improvement in labor markets and rebounding asset prices.
"I personally do not expect that it will be appropriate to raise short-term rates until the U.S. economy is within one year of both achieving full employment and returning to within a narrow band around 2 percent inflation," Rosengren said in his prepared remarks. "However, both the transition to higher rates and the operating procedure for doing so could entail financial stability effects that should be thoughtfully considered – and I am certain will be."
When appropriate, the Fed could also raise the interest rates it pays on excess reserves or engage in overnight reverse repurchase agreements, effectively collateralized loans to the Fed that would provide a risk-free rate of return to investors, Rosengren said.
"Regardless of the tools eventually chosen, history shows that monetary policy ‘exits’ can be unsettled … Effective and transparent communication has become even more important," he said. "While the new policies have been instrumental in achieving better economic outcomes, clearly they are not without challenges … We need to seize this opportunity to carefully consider a broader set of monetary policy tools – and how those tools impact financial stability in addition to inflation and unemployment."
Rosengren offered a few potential exit-strategy options, including the possibility of a gradual and transparent reduction in the Fed’s balance sheet, when that becomes appropriate. One possibility would be reinvesting "all but a percentage of securities on the balance sheet as they reach maturity," and gradually increasing that percentage.
Turning to raising rates, when appropriate, one tool would be raising the rate of interest that the Federal Reserve pays on excess reserves. Or, the Federal Reserve could engage in overnight reverse repurchase agreements, which are, in effect, collateralized loans to the Fed that would provide a risk-free rate of return to investors. The Fed "could in effect place a floor on how low short-term rates would fall in the marketplace" since investors would be unwilling to accept lower rates of return.
