Federal Reserve Insight Into Monetary Tightening

Econintersect: Contrary to belief, the release of  the official meeting minutes for the Federal Reserves 26 / 27 April 2011 Federal Open Market Committee (FOMC) had original content.  Most pundits believed that Fed Chairman Ben Bernanke covered the FOMC meeting discussion in his press conference on 27 April (see coverage here). 

For starters, there was a major discussion of how the Fed was going to start tightening its monetary policy. 

The first key issue was the extent to which the Committee would want to tighten policy, at the appropriate time, by increasing short-term interest rates, by decreasing its holdings of longer-term securities, or both.  Because the two policies would restrain economic activity by tightening financial conditions, they could be combined in various ways to achieve similar outcomes. For example, in principle, the Committee could accomplish essentially the same degree of monetary tightening by selling assets sooner and faster but raising the target for the federal funds rate later and more slowly, or by selling assets later and more slowly but increasing the federal funds rate target sooner and faster.  The SOMA portfolio could be reduced by selling securities outright, by ceasing the reinvestment of principal payments on its securities holdings, or both.

A second key issue was the extent to which the Committee might choose to vary the pace of any asset sales it undertakes in response to economic and financial conditions. If it chose to make the pace of sales quite responsive to conditions, the FOMC would be able to actively use two policy instruments—asset sales and the federal funds rate target—to pursue its economic objectives, which could increase the scope and flexibility for adjusting financial conditions. In contrast, sales at a pace that varied less with changes in economic and financial conditions and was preannounced and largely predetermined would leave the federal funds rate target as the Committee’s primary active policy instrument, which could result in policy that is more straightforward for the Committee to calibrate and to communicate.

The above discussion was seemed to be background, as it appears the Fed already has the gameplan:

A majority of participants preferred that sales of agency securities come after the first increase in the FOMC’s target for short-term interest rates, and many of those participants also expressed a preference that the sales proceed relatively gradually, returning the SOMA’s composition to all Treasury securities over perhaps five years.

…….to normalize the conduct of monetary policy, it was agreed that the size of the SOMA’s securities portfolio would be reduced over the intermediate term to a level consistent with the implementation of monetary policy through the management of the federal funds rate rather than through variation in the size or composition of the Federal Reserve’s balance sheet.

………….exit strategy would involve returning the SOMA to holding essentially only Treasury securities in order to minimize the extent to which the Federal Reserve portfolio might affect the allocation of credit across sectors of the economy.

This leaves the $2.4 trillion question – when will this tightening begin.  Here, there were no signals from the Fed, but the market is expecting tightening before the end of the year.

Committee’s decision to discuss the appropriate strategy for normalizing the stance of policy at the current meeting did not mean that the move toward such normalization would necessarily begin soon.

There was little new economic information that was not reported during the 27 April press conference except on inflation.

Participants discussed the recent rise in inflation, which had been driven largely by significant increases in energy and, to a somewhat lesser extent, other commodity prices. These commodity price increases, in turn, reflected robust global demand and geopolitical developments that had reduced supply. One participant suggested that excess liquidity might be leading to speculation in commodity markets, possibly putting upward pressure on prices.

Source: Federal Reserve