Atlanta Fed president Dennis Lockhart, speaking at the NABE policy conference today, provided some useful thinking about Fed exit strategy from its current easy monetary policy.
Judgments regarding when to change the direction of policy are difficult, and much of our thought and energy are devoted to getting it right. But by employing a forward-looking Taylor-rule framework, when to exit is not a particularly bewildering problem conceptually.
A forward-looking Taylor rule will surely be a dominant influence on thinking about the timing of exit within the Fed. There are lots of forward-looking Taylor rules, and depending on your forecasts and the parameters you set, you can get pretty much any answer you want. Mr Lockhart did not suggest a particular rule.
But mucking about with a few of those that we know the Fed looks at because they’re in the 2004 Blue Books, and using the rule of thumb that $200bn of QE equals 25 basis points off the Fed Funds rate, then current policy starts to look wrong if you forecast year ahead unemployment below 8.5 per cent and year ahead core inflation of maybe 1.5 per cent (warning: back of the envelope calculation). Rules of this sort should be a decent guide to the timing of exit.
Mr Lockhart also commented a bit on the methods of exit:
Briefly, the implementation of the exit strategy would involve a combination, in some order, of increases in the federal funds rate target (supported by increases in the interest rate paid on excess bank reserves), the “locking up” of reserve balances through term deposit arrangements with banks and open market reverse repurchase operations, and outright sales of assets currently held by the Federal Reserve banks. It’s the right time to review and refresh those plans, particularly now that we are in the latter stages of LSAP2, but I think that the general approach remains workable.
But reading between the lines of the following paragraph I think there’s a recognition – which I’ve detected elsewhere in the Fed system – that starting exit with an extra $600bn of assets on the books is going to mean a need for greater aggression in reducing them.
It would be nice if we were to find ourselves in circumstances in which the large build-up in the Federal Reserve’s balance sheet could be unwound passively over time. Passive unwinding would be accomplished as the securities of the first and second asset purchase programs mature. It would be nice, but I think it highly unlikely such circumstances will prevail. In balance-sheet terms, it would resemble something like the current policy posture for several years.