Two Federal Reserve officials are making the case that the novel tools likely to be employed to push short-term interest rates higher don't necessarily augur a permanent policy-making overhaul, shedding light on the debate going on within the central bank.
New York Fed chief William Dudley and San Francisco Fed chief John Williams said this week that the new tools—including so-called reverse repos and interest paid on excess reserves—will likely have a role to play in lifting short-term rates from near zero, where they have been since the heights of the financial crisis in 2008.
The discussions on the mechanics of an eventual increase in short-term rates didn't address an explicit timetable. Mr. Dudley cautioned the Fed's first rate increase likely lies well in the future and no one knows for sure when it will happen. Mr. Williams said Monday that he thinks it will likely come some time in the second half of next year.
But they said the alternative exit strategies don't mean the Fed would retire its benchmark interest rate, the fed funds rate, which influences a host of other borrowing costs, including rates on mortgages, business loans and credit cards. Rather, they said, the Fed might use one combination of tools when it starts raising rates and use others later.
The choices now before the Fed "are about how to conduct monetary policy during the transitional phase," when it begins to lift rates, Mr. Dudley said in a speech Tuesday. The Fed isn't considering a total revamp of its long-term policy framework, he said.
Mr. Dudley's and Mr. Williams's comments show how the Fed is still experimenting with key parts of the financial system more than five years after the crisis. The Fed on Wednesday releases minutes of its recent policy meeting, at which discussions of these tools intensified.
The Fed's traditional system for moving rates higher or lower by adjusting the fed funds rate looks unlikely to work as effectively as it has in the past, so officials are discussing at least two alternative tools.
One is the interest rate the Fed pays on so-called excess reserves, the money banks deposit overnight at the central bank, now set at 0.25%. The rate is very low now to encourage banks to lend the money at higher rates to borrowers. When the economy strengthens and the Fed wants to restrain lending to prevent an outbreak of high inflation, it could raise this rate to encourage banks to leave money with the central bank.
The other tool, in testing since last September, is a rate on so-called reverse repurchase agreements, or reverse repos. Through these, the Fed takes in cash from eligible financial firms in exchange for one-day loans of Fed-owned Treasurys. The Fed could raise the repo rate in the future and expect other borrowing costs in the economy to rise, too.
The success of the reverse repos in testing has raised questions about whether Fed officials might eventually replace the fed funds rate as the Fed's primary method of raising rates.
Mr. Williams told reporters he doesn't think the Fed needs to retire the fed funds rate. But he said the reverse repos "should be part of our tool kit as we try to move interest rates up over time. That to me is separate to the issue of whether we use fed funds as our target, or we use another policy."
Mr. Dudley said the tools aren't mutually exclusive. The Fed could use some combination of them initially, but could change its approach later.
While "no decisions have been made," Mr. Williams said, "it would be perfectly appropriate" to raise rates on both reverse repos and on excess reserves, and accept that the fed funds rate will be more volatile than in the past.
"Eventually, it may only take months, it may take longer, [but] we'll be able to use the tools we use to maybe pinpoint that rate on a daily basis more carefully," Mr. Williams said.
Source : http://stream.wsj.com/story/markets/SS-2-5/SS-2-536569/
