One of the US Federal Reserve's most influential officials has called for a change to its exit strategy from easy monetary policy.
William Dudley, president of the New York Fed, said the central bank should keep reinvesting in its mortgage portfolio until after it raises interest rates. The current exit strategy calls for stopping reinvestment before rates go up.
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The call for the Fed to keep its mortgage portfolio larger for longer signals how exit strategy is now the most active policy debate at the central bank as the US economy gets closer to full employment. The possibility of more sustained Fed demand may boost markets for mortgage-backed securities.
Mr Dudley said that raising interest rates would give the Fed the flexibility to cut them again if the economy gets into trouble, so it is more important than reducing the MBS portfolio.
"Delaying the end of reinvestment puts the emphasis where it needs to be – getting off the zero lower bound for interest rates," said Mr Dudley in a speech to the New York Association for Business Economists on Tuesday.
"In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer."
The Fed is still buying mortgage-backed securities every month as part of its effort to drive down long-term interest rates and support the economy. When someone pays back their mortgage, the Fed reinvests the money in new MBS. Stopping reinvestment would allow its portfolio to gradually decline.
In an upbeat speech on the economy, Mr Dudley signalled he is happy with tapering Fed asset purchases at the current pace of $10bn per meeting, and with current market expectations for a first rise in interest rates in the middle of 2015.
He also discussed how to go about raising interest rates – which requires new tools because the Fed will be doing so with a balance sheet bloated to $4tn.
Mr Dudley said that the early evidence suggests the Fed's experimental new "reverse repo" facility "would help strengthen our control over money market rates". The reverse repo facility basically lets funds and other counterparties deposit cash at a rate set by the New York Fed.
However, he raised two concerns: first that setting the reverse repo rate too high could encourage growth in the shadow banking system by giving non-banks an attractive place to park their cash, and second that it could encourage bank runs by providing an attractive place for panicked investors to escape to.
He suggested these issues could be addressed via a somewhat lower interest rate on the reverse repos and by limits on use of them during times of financial stress. "This could be done by building in circuit breakers such as caps on overall usage of the facility," he said.
Mr Dudley said that a second option of letting banks make longer-term deposits at the Fed could lead to higher interest expenses for the central bank.
"The choices here are important," he said. "My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term interest rates."
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