Donald L Kohn: Central bank exit policies
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Cato Institute's Shadow Open Market Committee Meeting,
Washington DC, 30 September 2009.
* * *
I am pleased to be on this panel on exiting from the unusual policies the Federal Reserve
and other central banks have put in place to ameliorate the effects of the financial turmoil of
the past two years. Chairman Bernanke has made a concerted effort to explain the thinking
of the Federal Reserve in this regard, because it is so important that the public understand
we have the means to meet our objectives of fostering stable prices and high employment. I
will briefly underline some aspects of the Federal Reserve's framework for exiting that I
believe to be especially critical to that understanding.1
Conditions for exit
In its most important aspects, the decision about when to begin exiting from the unusual
policies is not materially different from any decision to start tightening monetary policy. We
will need to begin to remove the extraordinary degree of accommodation in its various
dimensions when we judge that exiting from the current stance of policy will be necessary to
preserve price stability as the economy returns to higher levels of resource utilization.
Because it takes people time to adjust their spending and pricing decisions in response to a
change in interest rates or other aspects of financial conditions, like other monetary policy
decisions, that judgment will need to be based on a forecast of economic developments, not
on current conditions. So we must begin to withdraw accommodation well before aggregate
spending threatens to press against potential supply, and well before inflation as well as
inflation expectations rise above levels consistent with price stability.
I cannot give you a small list of variables that will trigger an exit; as always, our forecasts will
use all available sources of information. And I can't predict how rapidly we will have to raise
short-term interest rates from around zero or remove other forms of accommodation; that too
depends on how the economy seems to be recovering and the outlook for inflation. Clearly,
the present degree of accommodation - as gauged by nominal and real short-term interest
rates and the size of our balance sheet - is extraordinary, and we will have to take account
of how that is influencing spending and inflation expectations when deciding when and how
fast to tighten.
Tools for exit
We have the framework to exit from these policies when we need to do so. And the tools at
our disposal will allow us to do so at the pace and in the sequence we judge will best meet
our objectives.
Most importantly, our ability to pay interest on reserves will enable us to raise short-term
interest rates even while the quantity of assets we hold is still quite elevated and while the
reserve base of the banking system is extraordinarily high. The opportunity for banks to earn
interest on a highly liquid risk-free deposit at the Federal Reserve should put a reasonably
firm floor under short-term rates, including the federal funds rate. To date, that floor has been
somewhat soft, perhaps because not all participants in the federal funds market can hold
deposits at the Federal Reserve, and because banks have been reluctant to allocate the
needed capital to arbitrage a few basis points. But I am confident that when we begin to raise
our deposit rate, it will put upward pressure on the rates on competing assets, increasing
actual and expected short-term interest rates with the usual types of effects on other interest
rates and asset prices. As banks become more comfortable with their capital levels, they will
be more willing to undertake the arbitrage to tighten the link between the rate on deposits
and short-term market interest rates.
Still, draining reserves at some point also will be an aspect of exiting. The large volume of
reserves is contributing to the loose relationship of our deposit rate and market rates. In
addition, although to date the high volume of reserves evidently has not increased bank
lending or reduced spreads of rates on bank loans or other assets relative to, say, Treasury
rates, it could begin to do so if banks start to perceive the risk-adjusted returns on loans as
superior to our deposit rate. An increase in lending and narrowing of spreads on bank loans
is a necessary and desirable aspect of the return to better-functioning markets and
intermediation to promote economic growth. But spreads eventually could become narrower
than what would be consistent with underlying risk, and lending could grow more quickly than
appropriate for price stability if very high levels of reserves remain in place. We are
developing new techniques for draining reserves, including reverse repurchase agreements
against mortgage-backed securities and time deposits for banks at the Federal Reserve.
And, of course, we retain the option to sell securities from our portfolio on an outright basis.
The range of tools will permit us to drain large volumes of reserves if necessary to achieve
the policy stance that fosters our macroeconomic objectives.
Our lending programs were designed to wind themselves down as market conditions
improve, and they are doing so. When conditions are no longer unusual and exigent, those
programs not focused on depository institutions will be terminated, and, with a few
exceptions such as the Term Asset-Backed Securities Loan Facility, they will leave no
residual on our balance sheet.2
The long-term securities we are buying will not run off so rapidly. But the effects of our
holdings of mortgage-backed and agency securities on spreads nonetheless should decline
even if they remain on our balance sheet. For one, some of the spread compression may
result from the flow of our purchases, as well as our stock of holdings, and as we already
announced, we will be tapering down our purchases. Moreover, the stock of assets we own
will become an ever smaller share of a growing market. Finally, as confidence returns, asset
demands will become less focused on particular classes of highly safe and liquid assets and
more sensitive to relative interest rates, and private participants will arbitrage away at least
some of any remaining spread distortions. Nonetheless, if, in the course of removing
accommodation, the Federal Open Market Committee (FOMC) perceives spreads to be
distorted or longer-term interest rates to be not responding appropriately, it could consider
sales of these assets.
Communication about exit
The unusual nature of our actions and the uncertainty about when and how they will be
unwound suggest an even greater payoff than usual from being as clear as possible in our
communications with the public. I already noted the importance of the public's understanding
that we can and will exit from these policies when that is necessary to achieve our objectives
for stable prices and maximum employment. In addition, we will need to explain especially
carefully - in our policy announcements, the minutes of our meetings, and our quarterly
forecasts - the evolution of our assessment of the economic situation and the risks
associated with achieving our goals. Finally, we will need to be sure our rate guidance
evolves along with our assessment of the probability that the exit is drawing closer.
Conclusion
Although economic conditions have apparently begun to improve - partly in response to the
extraordinary steps the Federal Reserve and other authorities have taken - resource
utilization is quite low, inflation is subdued, and continuing restraints on credit are likely to
constrain the speed of recovery. For that reason, as the FOMC stated last week,
exceptionally low interest rates are likely to be warranted for an extended period. Given the
highly unusual economic and financial circumstances, judging when the time is appropriate
to remove policy accommodation, and then calibrating that removal, will be challenging. Still,
we need to be ready to take the necessary actions when the time comes, and we will be.