Fed Governor Brainard March 2017 Speech Notes

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THe economy is at a transition

“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.1

The focus is turning to balance sheet

“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.”

We are closing in on full employment

“Here at home, the economy is at a transition. The past few months have seen continued progress in the labor market. Monthly gains in payroll employment have maintained a pace sufficient to continue eroding labor market slack, and wage growth appears to be moving higher on balance. Compensation per hour in the business sector, the most comprehensive measure of wages, increased at a 3 percent pace the past two years, noticeably above the pace earlier in the recovery. We appear to be closing in on full employment. The unemployment rate–after remaining relatively flat from the third quarter of 2015 to the third quarter of 2016–fell 1/4 percentage point last quarter to 4-3/4 percent

There are upside risks to demand

“Recent months have seen an increase in the upside risks to domestic demand. Sentiment has increased along with equity prices, which are up around 10 percent since October. Increased optimism could lead to faster growth in consumption and business investment, although the spending data, thus far, do not suggest a noticeable acceleration. Some of the increase in sentiment and changes in asset prices could be tied to expectations of more expansive fiscal policy, another upside risk.”

Decision to rely on increases in fed funds serves an important purpose

‘In December 2015, the Committee indicated that it would continue to reinvest principal payments until normalization of the level of the federal funds rate is “well under way.”2 The decision to rely solely on the federal funds rate to remove accommodation initially until normalization is well under way serves an important purpose, in my view.3 With asymmetry in the scope for conventional monetary policy to respond to shocks, there is a benefit to enabling the federal funds rate to rise more quickly than would be possible with a shrinking balance sheet and sooner reach a level that allows for significant reductions if economic conditions deteriorate”

There are two policy options for the balance sheet use it as a tool or subordinate it

“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.5 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 short-term 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.6 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”

We should focus on the rate policy tool

“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 prices.7 However, relative to balance sheet policies, the influence of the short-term rate is far better understood and extensively tested: There have been several decades and many business cycles over which to measure and analyze how the federal funds rate affects financial markets and real activity. In contrast, experience using the balance sheet as an active tool has been very limited and largely confined to a highly unusual period around the Global Financial Crisis, when short-term interest rates were constrained by the zero lower bound. Predictability, parsimony, precision, and clarity of communications all would seem to argue in favor of focusing policy on a single active tool that is most familiar. In short, it makes sense to focus policy on the tool whose effects are better understood by both policymakers and the public in circumstances where the tools are largely substitutes for one another.

The balance sheet will likely be considerably smaller than it is today

“Assuming that a subordination strategy is adopted, and the balance sheet is set to shrink passively and predictably once reinvestment ceases or is phased out, there is some uncertainty around the size of the balance sheet when it returns to normal, which the Committee has described as “no larger than necessary for the efficient and effective implementation of monetary policy.” There are good reasons to expect a normalized balance sheet to be considerably smaller than its current size but larger than its pre-crisis level. Most obviously, trend growth in the demand for currency gradually pushes up the size of the balance sheet over time, but there are also other reasons to expect the post-crisis new normal to be larger than pre-crisis levels. The structural demand for reserves may be considerably larger now than prior to the financial crisis because of a number of changes, including new regulations that favor safe liquid assets and changes in financial institutions’ attitudes toward risk”