Hilsenrath's Take: Fed Considering New Exit Strategy -WSJ
At a policy meeting in June 2011, Federal Reserve officials agreed on a long-term plan to eventually exit sometime in the future from their unconventional monetary policies and return to its interest-rate-setting ways of the past. That plan is looking increasingly obsolete. The contours of a new plan are being debated within the Fed and slowly coming into shape.
Under the old plan, the Fed would take several steps to remove trillions of dollars it has pumped into the financial system. First it would let mortgage securities and Treasury securities mature and run off its balance sheet. Over a longer stretch it would sell mortgage-backed securities. Other technical tools – such as allowing banks to place deposits at the Fed for stretches – would further drain reserves in the financial system. Taken together these money draining moves would help to lift the Fed's benchmark interest rate, the federal funds rate, as the supply of money in the system became scarcer. The Fed would also pay an interest rate on bank reserves to anchor rates where it wants them.
Under a new plan being considered, the Fed could leave excess reserves in the banking system for years and may never remove them. In addition to paying interest on excess bank reserves, the Fed would anchor rates through a program using reverse repurchase agreements, or “reverse repos,” in which it trades with firms outside the banking system and pays them interest on cash they lend to the Fed. Rather than draining money from the financial system, and setting interest rates by managing its supply, the Fed would set interest rates by managing the cost of money. It would become the price setter through the interest rate it pays on it.
The Fed has already said that leaving all of this cash in the financial system means it might not actively sell mortgage-backed securities. Last week, New York Fed President William Dudley told The Wall Street Journal it also meant the Fed doesn't have to allow securities to mature and run off its balance sheet months in advance of rate increases, as previously planned. Under the old plan that runoff would be like a warning flare shot long before a race begins. Mr. Dudley's point means the shot now won't go off until right before the race begins.
None of this is yet set. Some Fed officials want to go back to the old days of scarce reserves. Moreover the reverse repo program which is key to the Fed's new thinking on exit comes with costs that could dissuade some officials. Among them, the reverse repo interest rate could overshadow or undermine the fed funds rate, which is a benchmark rate for many other financial contracts.
Fed Chairwoman Janet Yellen will need to get officials to agree on an approach in the months ahead. And investors will need to listen carefully, because the approach will include important signals on how the next rate-hike cycle will work.
- By Jon Hilsenrath
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