lael brainard : transitions in the outlook and monetary policy speech by ms lael brainard, member of the board of governors of the federal reserve system, at the john f kennedy school of government, harvard university, cambridge, massachusetts, 1 march 2017 * * * these remarks represent my own views, which do not necessarily represent those of the federal reserve board or the federal open market committee. the economy appears to be at a transition. we are closing in on full employment, inflation is moving gradually toward our target, foreign growth is on more solid footing, and risks to the outlook are as close to balanced as they have been in some time. assuming continued progress, it will likely be appropriate soon to remove additional accommodation, continuing on a gradual path. as normalization of the federal funds rate gets further under way, monetary policy too is approaching a transition, prompting increased focus on the balance sheet. how the federal funds rate and the balance sheet should be adjusted individually and in combination depends on the degree to which they are substitutes, their relative precision, and the degree to which their effects on the economy are well understood. let me start with the outlook and then turn to policy. progress at home and abroad over the past several quarters, we have seen improvement in inflation and activity both at home and abroad following a period when the drag on domestic activity from abroad was considerable. between the middle of 2014 and 2016, a combination of notable fragilities and risks in large foreign economies, elevated sensitivity of the dollar to policy divergence, a sharp decline in oil prices, and financial markets ’ heightened sensitivity to these downside risks slowed progress in the u. s. economy and the adjustment of monetary policy to an extent few had anticipated. after being an important constraint in the past few years, the external environment currently appears more benign than it has been for some time, even though risks remain. near - term risks to the united states from abroad appear to have diminished. recoveries are gaining traction in china, europe, and japan in part reflecting greater confidence in their respective policy environments. the improvement in the global risk outlook was also helped by the continued economic progress and the gradual pace of monetary policy adjustment in the united states last year. in recent quarters, market participants appear more confident that china has the will and capacity to maintain its exchange rate regime, while achieving its growth targets, although there is a tension with high credit growth that will eventually need to be addressed. early last year, china ’ s gross domestic

3 percent — a very low level by historical standards — some could judge normalization to be well under way before too long. thus, monetary policy too may be approaching a transition. once the short - term rate is comfortably distant from its effective lower bound, there are broadly two types of policy strategies that could be contemplated. many central banks around the world may contemplate similar choices in the coming years, while the bank of japan has already grappled with these issues in the past. 4 one type of “ complementarity ” strategy might actively deploy the balance sheet as an independent second tool, complementary to the short - term rate. under this strategy, both tools would be actively used to help achieve the committee ’ s goals. this strategy would seek to take advantage of the ways in which the balance sheet might affect certain aspects of the economy or financial markets differently than the short - term rate. any differences in effects might derive from the fact that the balance sheet more directly, though not necessarily more precisely, affects term premiums on longer - term securities, while the shortterm rate more directly affects money - market rates. although it may be tempting, in theory, to operate with the balance sheet as a complementary, additional tool to the federal funds rate, we have virtually no experience with how such an approach would work in practice away from the effective lower bound. for that reason, one might instead prefer a “ subordination ” strategy that would prioritize the federal funds rate as the sole active tool away from the effective lower bound, effectively subordinating the balance sheet. once federal funds normalization meets the test of being well under way, triggering an end to the current reinvestment policy, the balance sheet would be set on autopilot, shrinking in a gradual, predictable way until a “ new normal ” has been reached, and then increasing in line with trend increases in the demand for currency thereafter. 5 under this strategy, the balance sheet might be used as an active tool only if adverse shocks push the economy back to the effective lower bound. the case for the subordination strategy is straightforward and compelling. this strategy recognizes that the two policy tools are broadly similar in the ways they affect the economy by indirectly changing the level of interest rates used to finance purchases by households and businesses. these interest rate changes also have effects on asset prices, and thereby on household wealth, as well as on the exchange value of the dollar and, thereby, on net exports and core import