Today’s FOMC Minutes from the April meeting shed some light on their exit plan (or lack of a plan). They explicitly say that policy normalization will not necessarily begin soon. In essence, their plan appears to be ending QE2, followed by ending QE-lite (reinvestments) followed by rate increases and finally ending with asset sales. They place a 5 year timeframe on the entire exit strategy. In short, expect the Fed to remain pretty close to permanently accommodative:
“Meeting participants agreed on several principles that would guide the Committee’s strategy for normalizing monetary policy. First, with regard to the normalization of the stance of monetary policy, the pace and sequencing of the policy steps would be driven by the Committee’s monetary policy objectives for maximum employment and price stability. Participants noted that the Committee’s decision to discuss the appropriate strategy for normalizing the stance of policy at the current meeting did not mean that the move toward such normalization would necessarily begin soon. Second, to normalize the conduct of monetary policy, it was agreed that the size of the SOMA’s securities portfolio would be reduced over the intermediate term to a level consistent with the implementation of monetary policy through the management of the federal funds rate rather than through variation in the size or composition of the Federal Reserve’s balance sheet. Third, over the intermediate term, the exit strategy would involve returning the SOMA to holding essentially only Treasury securities in order to minimize the extent to which the Federal Reserve portfolio might affect the allocation of credit across sectors of the economy. Such a shift was seen as requiring sales of agency securities at some point. And fourth, asset sales would be implemented within a framework that had been communicated to the public in advance, and at a pace that potentially could be adjusted in response to changes in economic or financial conditions.
In addition, nearly all participants indicated that the first step toward normalization should be ceasing to reinvest payments of principal on agency securities and, simultaneously or soon after, ceasing to reinvest principal payments on Treasury securities. Most participants viewed halting reinvestments as a way to begin to gradually reduce the size of the balance sheet. It was noted, however, that ending reinvestments would constitute a modest step toward policy tightening, implying that that decision should be made in the context of the economic outlook and the Committee’s policy objectives. In addition, changes in the statement language regarding forward policy guidance would need to accompany the normalization process.
Participants expressed a range of views on some aspects of a normalization strategy. Most participants indicated that once asset sales became appropriate, such sales should be put on a largely predetermined and preannounced path; however, many of those participants noted that the pace of sales could nonetheless be adjusted in response to material changes in the economic outlook. Several other participants preferred instead that the pace of sales be a key policy tool and be varied actively in response to changes in the outlook. A majority of participants preferred that sales of agency securities come after the first increase in the FOMC’s target for short-term interest rates, and many of those participants also expressed a preference that the sales proceed relatively gradually, returning the SOMA’s composition to all Treasury securities over perhaps five years. Participants noted that, for any given degree of policy tightening, more-gradual sales that commenced later in the normalization process would allow for an earlier increase of the federal funds rate target from its effective lower bound than would be the case if asset sales commenced earlier and at a more rapid pace. As a result, the Committee would later have the option of easing policy with an interest rate cut if economic conditions then warranted. An earlier increase in the federal funds rate was also mentioned as helpful to limit the potential for the very low level of that rate to encourage financial imbalances. A few participants expressed a preference that sales begin before any increase in the federal funds rate target, and a few other participants indicated that sales and increases in the federal funds rate target should commence at the same time. The participants who favored earlier sales also generally indicated a preference for relatively rapid sales, with some suggesting that agency securities in the SOMA be reduced to zero over as little as one or two years. Such an approach was viewed as allowing for a faster return to a normal policy environment, potentially reducing any upside risks to inflation stemming from outsized reserve balances, and more quickly eliminating any effects of SOMA holdings of agency securities on the allocation of credit.
Most participants saw changes in the target for the federal funds rate as the preferred active tool for tightening monetary policy when appropriate. A number of participants noted that it would be advisable to begin using the temporary reserves-draining tools in advance of an increase in the Committee’s federal funds rate target, in part because doing so would put the Federal Reserve in a better position to assess the effectiveness of the draining tools and judge the size of draining operations that might be required to support changes in the interest on excess reserves (IOER) rate in implementing a desired increase in short-term rates. A number of participants also noted that they would be prepared to sell securities sooner if the temporary reserves-draining operations and the end of the reinvestment of principal payments were not sufficient to support a fairly tight link between increases in the IOER rate and increases in short-term market interest rates.
In the discussion of normalization, some participants also noted their preferences about the longer-run framework for monetary policy implementation. Most of these participants indicated that they preferred that monetary policy eventually operate through a corridor-type system in which the federal funds rate trades in the middle of a range, with the IOER rate as the floor and the discount rate as the ceiling of the range, as opposed to a floor-type system in which a relatively high level of reserve balances keeps the federal funds rate near the IOER rate. A couple of participants noted that any normalization strategy would likely involve an elevated balance sheet with the federal funds rate target near the IOER rate–as in floor-type systems–for some time, and therefore the Committee would accumulate experience during the process of normalizing policy that would allow it to make a more informed choice regarding the longer-term framework at a later date.
The Committee agreed that more discussion of these issues was needed, and no decisions regarding the Committee’s strategy for normalizing policy were made at this meeting.”
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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