Federal Reserve Bank of New York President William Dudley spoke yesterday on "The Economic Outlook and Implications for Monetary Policy," where he discussed the Fed's eventual "lift-off" of rates from the near zero levels currently and where he talked about the Fed's reverse repo program. Dudley says, "If my forecast is correct, as growth strengthens and inflation drifts higher, the focus will turn to monetary policy. In particular, what will be the timing of lift-off? And when lift-off occurs, how quickly will the Federal Open Market Committee (FOMC) raise rates and to what level? Also, with an exceptionally large balance sheet there will be considerable attention on the methods that the FOMC will likely use in order to exert control over the level of short-term rates. I can't tell you yet how we will do it, but I am fully confident that we have the necessary tools to control the level of short-term rates and the credit creation process, and I will share with you some of my own thoughts on the subject."
He explains, "Given my outlook for above-trend growth and inflation gradually drifting higher, the inevitable question is what this means for the monetary policy outlook. Over the near-term, if circumstances evolve relatively close to my forecast, I would continue to favor gradually reducing the pace of asset purchases by staying on the same glide path of a $10 billion reduction in the monthly purchase pace following each FOMC meeting. Assuming asset purchases end sometime this fall, the focus will shift to the timing of lift-off, the pace of tightening once lift-off occurs and where short-term rates are ultimately headed over the longer-term. The issue of how the Fed will manage its balance sheet will also be relevant, as well as how monetary policy will be conducted during a period when the amount of excess reserves in the banking system is unusually large. I will give you some of my early thinking on each of these issues in the remainder of my remarks."
Dudley comments, "Turning first to the timing of lift-off, how the outlook evolves matters. We currently anticipate that a considerable period of time will elapse between the end of asset purchases and lift-off, but precisely how long is difficult to say given the inherent uncertainties surrounding the outlook.... With respect to the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves. My current thinking is that the pace of tightening will probably be relatively slow.... In terms of the level of rates over the longer-term, I would expect them to be lower than historical averages."
He continues, "With respect to the issue of how the FOMC will control money market rates with an enlarged balance sheet, the Federal Reserve already has the necessary tool -- the ability to pay interest on excess reserves. However, the degree of control could be further buttressed. Enhancing confidence in the Fed's ability to control money market rates, and hence, inflation, might also help keep inflation expectations well anchored."
Dudley tell us, "One method the Fed has been testing is an overnight, fixed rate, reverse repo (RRP) facility. The Federal Reserve posts a fixed interest rate and accepts cash from counterparties, which include some banks, dealers, money market funds, and government sponsored enterprises, on an overnight basis in return for a security. The repo facility is "reverse" because the direction in which the funds and securities move -- participants are lending funds to the Fed rather than vice versa. Users of the facility are making the economic equivalent of an overnight collateralized loan of cash to the Federal Reserve. If implemented, the facility could be set up as "full allotment," which means that there is no cap on the amount of funds accepted from any of its counterparties at the posted overnight interest rate. Or, caps could be imposed on either an aggregate or per counterparty basis in order to limit total usage."
He states, "The amount of funds invested in the facility is likely to be sensitive to the spread between the posted interest rate and comparable money market rates and the level of caps placed on usage. The narrower the spread to comparable money market rates, the greater the participation is likely to be. In our ongoing tests with this facility, the New York Desk has varied the RRP rate from 1 to 5 basis points and the cap on usage by counterparty has gradually been increased to its current level of $10 billion. As expected, narrower spreads to comparable money market rates and larger caps have led to greater usage. Although the testing process is still ongoing, early results suggest that the overnight RRP facility will set a floor under money market rates. Treasury repo rates have generally traded no more than a basis point or two below the overnight RRP rate. Thus, the early evidence suggests that this facility would help strengthen our control over money market rates."
Dudley explains, "Two issues with the overnight reverse repo rate warrant careful consideration. The first is how big a footprint the facility should have in terms of volume. To the extent that the overnight RRP rate were set very close or equal to the interest rate on excess reserves (IOER) without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further development of the shadow banking system. If this were deemed undesirable, this would argue for a wider spread between the overnight RRP and the IOER in order to reduce the volume of flows into the facility. The second issue is the facility's potential impact on financial stability. In particular, would such a facility make financial instability less likely? And, when financial stress did occur, would such a facility amplify or dampen financial strains?"
He says, "On the first point, it seems that such a facility would tend to make financial instability less likely. The overnight RRP facility allows us to make a short-term safe asset more widely available to a broad range of financial market participants. The provision of short-term safe assets by the official sector might crowd out the private creation of runnable money-like liquid assets. This might enhance financial stability by reducing the likelihood of a financial crisis. However, if a financial crisis were to occur, the existence of a full allotment, overnight, RRP facility might exacerbate instability by encouraging runs out of more risky assets into the facility. That is because the supply of a full allotment facility would be completely elastic at the given fixed rate. Money market mutual funds and other providers of short-term financing could rapidly shift funds into the facility away from assets such as commercial paper that support the private sector. In contrast, in the current regime, when financial crises lead to flows into less risky assets, their interest rates fall, limiting the appetite for these less risky assets. Consequently, under a full allotment setup, runs could be larger and these runs could exacerbate the fall in the prices of riskier assets. Note that the risk here is how quickly financial flows could reverse from one day to the next, not the average level of take-up of the facility over time."
Dudley also comments, "Fortunately, this risk seems relatively easy to address. One could design the facility to prevent rapid inflows during times of financial stress. This could be done by building in circuit breakers such as caps on overall usage of the facility. The circuit breakers would not affect the amount of take-up during normal times or prevent take-up from rising at moderate rates. Instead, they would be in place to limit the pace and magnitude of inflows during times of stress. A second option to improve the Fed's control over short-term rates is to drain reserves by offering banks term deposit accounts in which to invest funds for longer terms than overnight. There are two issues that might make this option somewhat less attractive. First, to strengthen monetary policy control significantly through this course, it might be necessary to drain most of the $3 trillion of reserves. This could be done of course with effort, but is the effort worth it?"
He adds, "Second, the Fed would undoubtedly have to "pay up" to induce banks to hold term deposit accounts relative to keeping their monies in reserves at the excess reserves interest rate. `This would likely result in higher Fed interest expenses relative to relying on an overnight RRP facility to set a floor on money market rates. The choices here are important and I expect that considerable testing, analysis and discussion will be necessary to reach firm conclusions about the appropriate course. My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term rates."
Finally, Dudley says, "I also think that the choices are about how to conduct monetary policy during the transitional phase, not about the long-term monetary policy framework. Longer term, the issue will be whether to return to the type of corridor system that was in place prior to the crisis or to instead to stay with the type of floor system that will likely be the type of regime that is in place as the balance sheet gradually normalizes. I expect that the choices made over the near-term can be implemented in a way so as not to forestall either a corridor or a floor system over the longer term. The experience we gain with operating monetary policy effectively with a very large balance sheet will undoubtedly inform that choice. But, that topic is putting the cart far before the horse. First, we need an economy that is strong enough to more fully utilize the nation's labor resources and to begin to push inflation back towards the Federal Reserve's long-term objective. Only then can the monetary policy normalization process proceed. Although we are making progress towards our goals, we still have a considerable way to go."
