Many Nuggets of Information about Fed’s Exit Policies from Vice Chairman Kohn
Vice Chairman Kohn’s preemptive stance (see excerpt below) on the timing of monetary policy is not surprising:
“So we must begin to withdraw accommodation well before aggregate spending threatens to press against potential supply, and well before inflation as well as inflation expectations rise above levels consistent with price stability.”
Hints about the degree of monetary policy tightening -- whether aggressive or gradual -- are missing; guidance is crafted cautiously in the description below. Inflation expectations are most likely to establish the pace of tightening and the timing of Fed action:
“I cannot give you a small list of variables that will trigger an exit; as always, our forecasts will use all available sources of information. And I can't predict how rapidly we will have to raise short-term interest rates from around zero or remove other forms of accommodation; that too depends on how the economy seems to be recovering and the outlook for inflation. Clearly, the present degree of accommodation--as gauged by nominal and real short-term interest rates and the size of our balance sheet--is extraordinary, and we will have to take account of how that is influencing spending and inflation expectations when deciding when and how fast to tighten.”
Currently, inflation expectations (chart 1) are well contained and the recent trajectory is below the pre-crisis level, suggesting that the enormous slack in the economy is playing a significant role in the formation of inflation expectations.
The Fed commenced compensating reserves of depository institutions with interest payments from October 22, 2008. The Fed differentiated between required and excess reserves by paying a higher rate on required reserves compared with excess reserves and both rates were set lower than the target federal funds rate (see chart 2).
These differences were phased out on November 19, 2008, with the target federal funds rate and interest rates on required and excess reserves becoming identical (chart 3). But, the effective federal funds rate continues to hold below the target rate (see chart 3).
Kohn noted that the Fed’s “ability to pay interest on reserves will enable us to raise short-term interest rates even while the quantity of assets we hold is still quite elevated and while the reserve base of the banking system is extraordinarily high. The opportunity for banks to earn interest on a highly liquid risk-free deposit at the Federal Reserve should put a reasonably firm floor under short-term rates, including the federal funds rate.” It appears that the interest rate on reserves and the effective federal funds rate will be additional rates to track to understand the likely course of monetary policy. He elaborated the potential scenario as follows:
“To date, that floor has been somewhat soft, perhaps because not all participants in the federal funds market can hold deposits at the Federal Reserve, and because banks have been reluctant to allocate the needed capital to arbitrage a few basis points. But I am confident that when we begin to raise our deposit rate, it will put upward pressure on the rates on competing assets, increasing actual and expected short-term interest rates with the usual types of effects on other interest rates and asset prices. As banks become more comfortable with their capital levels, they will be more willing to undertake the arbitrage to tighten the link between the rate on deposits and short-term market interest rates.”
Vice Chairman Kohn also indicated that the Fed is developing new tools to drain reserves, which he described as follows:
“We are developing new techniques for draining reserves, including reverse repurchase agreements against mortgage-backed securities and time deposits for banks at the Federal Reserve. And, of course, we retain the option to sell securities from our portfolio on an outright basis. The range of tools will permit us to drain large volumes of reserves if necessary to achieve the policy stance that fosters our macroeconomic objectives.”
The Fed’s balance sheet has grown rapidly in a short period of time. But, they will remain on the books for far longer than it took to accumulate them. Kohn alluded to this eventuality when he mentioned that “the long-term securities we are buying will not run off rapidly.” He also noted that “if in the course of removing accommodation, the Federal Open Market Committee (FOMC) perceives spreads to be distorted or longer-term interest rates to be not responding appropriately, it could consider sales of these assets.” The expected caveats about the reasons for clear communication of policy and the challenge of timing and calibration of exit policy were included in Kohn’s speech.
Revisions of Q2 GDP were Small, Government Investment Outlays Remain Noteworthy
Real gross domestic product fell at an annual rate of 0.7% in the second quarter, marginally better than the 1.0% decline estimate reported in August. Among the business spending components, equipment and software outlays (-4.9% vs. -8.4% in the previous estimate) were less weak than previously estimated and expenditures on structures (-17.3% vs. -15.1%) were weaker than the preliminary estimate. A slightly smaller trade reflects upward revisions of exports and imports.
The details of government spending are noteworthy in addition to the upward revision of the entire component (see table below) of government spending. The full impact of the fiscal stimulus package is not here yet but we are seeing early signs of the programs by way of gains in investment outlays across the different ranks of government agencies from the federal to the local level (see chart 5). Looking forward, real GDP is predicted to have risen at a 2.5% annual rate in the third quarter of 2009, followed by more tepid growth in the next two quarters.
