Early Observations on Gradual Monetary Policy Normalization
Speaking to the Greater Boston Chamber of Commerce, Boston Fed President Eric Rosengren reflected on the progress of the U.S. economy over the last year, calling December's short-term interest rate increase by Fed policymakers an important milestone. The future path of rates, he said, will depend on incoming economic data, and how that data affects policymakers' outlook for the economy.
"I hope the economy continues to improve, so that further normalization is appropriate. It is important, however, to carefully manage risks to the economy," said Rosengren - adding that, in his view, further increases in rates are likely to be gradual. This gradual notion reflects the current economic landscape, including the fact that inflation remains well below the Fed's 2 percent target.
Rosengren noted the good news on employment, with 292,000 jobs added in December, and an average of 284,000 jobs added per month over the past quarter. However, other news around the start of the year has been less positive, including weak stock markets in much of the world, weak oil and commodity prices, and falling estimates for fourth-quarter real GDP growth in the United States.
"While monetary policy should not overreact to short-term, temporary fluctuations in financial markets, policy makers should take seriously the potential downside risks to their economic forecasts," he said.
Rosengren observed that improvements in the economy "provided the conditions necessary for the Federal Reserve to finally begin removing some of the extraordinary monetary policy accommodation that was the necessary, appropriate, and effective response to the financial crisis, recession, and painfully slow recovery." The first step in this gradual process was December's increase in the federal funds rate - the first since the Great Recession. He added that the response to the increase was quite uneventful.
Given the extremely large volume of excess reserves in the market post-crisis, increasing the federal funds rate this time requires different tools: borrowing facilities with administered interest rates, rather than relying on changing the balance of reserves in the banking system to influence rates. "These administered rates help us create the top and bottom of the new target range for the federal funds rate."
After the December FOMC meeting, the interest rate on reserves was set at 0.50 percent (the upper end of the target range) and the reverse repurchase rate was set at 0.25 percent (the lower end). The effective federal funds rate has traded in between those two rates all but one day (December 31).
While December's first increase was the beginning of normalization, Rosengren noted that rates remain well below their pre-crisis levels. He added that the Fed?s policy committee stated it "expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate."
Audio from President Rosengren's talk will air on Boston NPR affiliate WBUR at 8 p.m. EST on Jan. 17. The audio will also be available on the Greater Boston Chamber of Commerce website: http://bostonchamber.com/tag/government-affairs-forum/