"Extended Period?” May 22, 2010, Bob Eisenbeis, Chief Monetary Economist
How Long Is an “Extended Period of Time?”
The Federal Open Market Committee minutes from its April meeting provide an interesting window into the Committee’s current thinking about both its exit strategy and tactics to get back to a more normal policy environment. Parsing these minutes also reveals that “extended period of time” has just become longer than many have been expecting – likely well into next year or even beyond. What is it that drives this conclusion?
The first time the Committee made a significant policy move after it began providing accompanying statements indicating what happened was in February 1994. The minutes of the preceding meetings leading up to that policy move suggested that real GDP growth had been steady and above-trend for several quarters, the unemployment rate was about three percentage points below its current rate, the Beige book and discussions by the Reserve Bank presidents of local economic conditions indicated that growth was widespread and, finally, while there was little sign of inflation accelerating in 1994, CPI inflation was running about 3%, nearly one hundred and fifty basis points higher than it is now. Perhaps more importantly, the transcripts from that time indicated that there was considerable discussion and concern about the market reaction to that first move, and Chairman Greenspan prevailed, arguing for only a 25-basis-point initial move. I would expect that those same concerns to be relevant this time, but it is more complicated now because of the tendency of the FOMC to provide forward guidance to markets on future policy moves. Thus, the discussion this time will likely encompass substantial consideration of whether to pre-announce the impending move by changing or, more precisely, by dropping the “extended period” language from the statement. Now it is possible that concern about impending market reactions – which could be significant due to the heavy investment in bond portfolios acquired when rates were near zero – will take the Committee some while to resolve. The fear of a run for the door, once rates begin to increase, might result in an abrupt and large jump in interest rates that would put the FOMC in the policy position of chasing the market if rates accelerate more than expected. One possible scenario to temper that reaction might be for the Committee to take a series of baby steps, by modestly revising the language through more than one series of statements before actually moving rates.
In the meanwhile, the FOMC has also devised tactics for neutralizing the inflation threat of a rapid credit expansion fueled by the substantial volume of existing excess reserves created during 2009. The Committee is pinning its hopes on offering term deposits and reverse repurchase arrangements to temporarily idle those excess reserves. Both programs are still in development. The Term Deposit Program has been announced and will parallel the Term Auction Facility. Term deposits will be auctioned, initially in maturities that parallel the TAF. Demand for those deposits is uncertain, but given that the deposits would be acceptable collateral for discount-window loans, placing excess reserves in term deposits represents a riskless arbitrage and demand could be unexpectedly high. Should a bank need liquidity, it could also borrow at the discount window at a rate below that on the term deposits. In short, the proposed program represents a subsidy program to banks. As for the reverse repurchase arrangements, pilot programs have been experimented with, but there is a need to refine the program and to broaden significantly the range of potential counterparties.
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