Having pivoted to a dovish stance at its end-January policy meeting, the Federal Reserve proceeded to outline the details of its position over the past month.
Not only is the central bank pausing its interest rate increases, perhaps for the whole year, it will also suspend its balance sheet runoff later this year, maintaining a high level of liquidity in the banking system. And the policy-making Federal Open Market Committee is moving closer to consensus on exceeding its 2% inflation target to make up for the long period of inflation below that target.
Fed Chair Jerome Powell affirmed all this in two days of congressional testimony at the end of February after a series of FOMC members had spelled it out in detail.
Powell told the House financial services committee the Fed will be able to ‘stop the runoff later this year.’ The FOMC will probably be announcing its plan ‘fairly soon.’
During the hearing, Senator Patrick Toomey challenged the notion of surpassing the inflation target. The Pennsylvania Democrat could remember the problems of runaway inflation from the late 1970s and urged caution in letting price increases exceed the 2% target.
Powell countered that inflation expectations were anchored too low and the Fed needs to raise them to keep the inflation target credible. ‘In our thinking, inflation expectations are the most important driver in actual inflation,’ Powell said, by way of explaining to the senator how things have changed.
It was Fed governor Lael Brainard who first said earlier in the month that the Fed would stop its quantitative tightening later this year. She told an interviewer at CNBC that the Fed would not be shrinking its balance sheet by much more than it already has and would keep bank reserves at a much higher level than before the crisis.
‘My own view is that the balance sheet normalisation process should probably come to an end later this year,’ she said. Bank reserves had already declined 40% from their peak, to $1.6tn, she noted, so ‘the balance sheet normalisation process has done the work it was supposed to do.’
San Francisco Fed chief Mary Daly, meanwhile, suggested that quantitative easing would remain in the central bank’s toolkit going forward, not for the regular conduct of monetary policy but in cases where the Fed was squeezed for alternatives.
The Fed is monitoring the economy for any long-term effects of quantitative easing. For the moment, however, Daly said, ‘I don’t have any experience so far that would suggest, from looking at the research on this, that we should throw any of those tools out.’
The FOMC’s two heavyweight economists, Richard Clarida and John Williams, made the case for going over the inflation target at a monetary policy conference in New York.
Clarida, a Columbia University economist who is now vice-chair of the board of governors, said the Phillips curve linking inflation to unemployment has flattened and left inflation expectations anchored below the Fed’s target. The central bank is now considering a ‘makeup’ strategy of allowing inflation to exceed the target for a time and keep it credible as an average.
‘The benefits of the strategy rest heavily on households and firms believing in advance that the makeup will be delivered when the time comes,’ Clarida told the New York audience.
John Williams, head of the New York Fed and vice-chair of the FOMC, noted that inflation has averaged only 1.8% over the past 25 years, lagging consistently behind the Fed’s target and suggesting that a new framework for targeting is necessary.
Cleveland Fed chief Loretta Mester portrayed all of this as a successful normalisation. Somewhat more hawkish than other FOMC members, she felt that the Fed may raise interest rates later this year if the economy performs as well as she expects. But in pausing interest rates and setting an end to the balance sheet runoff, ‘we are transitioning back to normal monetary policy-making,’ she said at an event at the University of Delaware.
Patrick Harker, head of the Philadelphia Fed, agreed that a rate increase this year could be in the cards if the economy progresses as expected, with another one next year. Given the uncertainties, though, ‘I continue to be in a wait-and-see mode,’ he added at a Philadelphia event.
At a separate event, Harker said the Fed is comfortable with the current level of reserves, allowing it to stop reducing its balance sheet. ‘Reserves would then diminish at a very gradual pace,’ he said, ‘reflecting the trend growth of other Federal Reserve liabilities.’