simon m potter : interest rate control during normalization remarks by mr simon m potter, executive vice president of the markets group of the federal reserve bank of new york, at the sifma conference on securities financial transactions, new york city, 7 october 2014. * * * i would like to thank josh frost, lorie logan, and matthew raskin for their excellent assistance in the preparation of these remarks and colleagues in the federal reserve system for numerous insightful comments and suggestions. thank you, rob. i appreciate the opportunity to participate in this important event. securities financing markets are essential to the efficient functioning of the global financial system, and to the implementation of monetary policy in the united states and abroad. as you know, the federal open market committee ( fomc ) recently published a statement on its policy normalization principles and plans. today i would like to talk about these principles, and more specifically, about how the committee plans to raise and control shortterm interest rates when it becomes appropriate to do so. obviously, these plans are of interest to the open market trading desk ( the desk ) as we must implement the directives issued by the fomc after each meeting, and i am responsible for reporting to the fomc on the transactions made to meet its operating target. i ’ ll also review the overnight reverse repurchase agreement ( on rrp ) operations that the federal reserve has been testing for the past year, and explain recent changes the committee made to these operations. of course, the principles and continued testing are part of prudent planning, and do not imply that normalization will necessarily begin soon. as always, the views i express are mine alone and do not necessarily reflect those of the federal reserve bank of new york or the federal reserve system. the committee ’ s normalization principles and plans let me start by briefly reviewing the statement on normalization principles and plans that the fomc published following its september meeting. importantly, this statement is intended to provide the public with information about the eventual normalization process and does not signal a change in the current or future stance of policy. as the committee indicated in its september post - meeting policy statement, it continues to anticipate that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the committee ’ s 2 percent longer - run goal, and provided that longer - term inflation expectations remain

between the current level and the neutral level. for example, a short - term rate that appears highly stimulative under standard assumptions may in fact be much less so under alternative estimates of the neutral real rate. if the neutral real in contrast, optimal control simulations using frbus put the federal funds rate liftoff in 2015 ; see vice chair yellen ’ s speech of april 12 ( http : / / www. federalreserve. gov / newsevents / speech / yellen20120411a. htm ). for more details on this forecast, go to : http : / / libertystreeteconomics. newyorkfed. org / 2012 / 05 / just - released - the - new - york - fed - staff - forecast - may - 2012. html. this estimate should be considered very imprecise. to generate this estimate we first need to estimate how much long - term rates have been pushed down because of the federal reserve balance sheet programs. although there is considerable uncertainty, new york fed staff has estimated that the fed ’ s programs have pushed down the term premium by about 50 basis points. the question then becomes how much would the federal funds rate have to fall to generate the same result? that depends on how changes in the federal funds rate pass through to longer - term interest rates. if reductions in the federal funds rate were viewed as permanent, then the pass - through would presumably be 1 to 1. however, if the federal funds rate reductions were viewed as fully transitory, then there would be virtually no pass - through. econometric estimates indicate a value of about 4 to 1, a four basis points reduction in the federal funds rate would lead to a one basis point reduction in long - term rates. however, this degree of pass - through seems too low in the current environment in which the reductions in the federal funds rate have been in place for some time and are expected to continue for several more years. if one assumes a parameter value of 3 to 4 and uses 50 basis points as the estimate of the balance sheet impact on longer - term rates, then this implies that these actions have been equivalent to a 150 to 200 basis point reduction in the federal funds rate currently. as the onset of balance sheet normalization comes closer over time, the effect of the federal reserve ’ s balance sheet actions on the term premium will gradually diminish. this means that the size of the federal funds rate adjustment should also dimini