–A Few Members Said May Need Tightening ‘Sooner than Anticipated’
–First Tightening Step Should Be an End to Reinvestment,Extended Period

By Steven K. Beckner

(MNI) – The Federal Reserve’s policymaking Federal Open Market
Committee held an extensive discussion of its “exit strategy” options at
its late April meeting, but minutes of the meeting released Wednesday
emphasize that this discussion did not imply that the FOMC would be
tightening monetary policy soon.

While “a few” FOMC participants thought the Fed might need to
tighten policy “sooner than currently anticipated” — possibly later
this year — to curb inflation pressures, others were more sanguine
about inflation risks and more inclined to keep monetary stimulus in
place to support economic growth and employment.

The minutes show that the committee was in general agreement that
it would take a very adverse turn of events to justify another round of
quantitative easing after the second round (QE2) ends in June, as the
FOMC approved.

Looking toward eventual tightening, a majority of FOMC members
agreed that the first exit steps should be to end reinvestment of
principle payments on the Fed’s securities holdings and to remove from
the FOMC policy announcement the commitment to keep the federal funds
rate “exceptionally low” for an “extended period.”

While “a few” thought the next step in the exit process should be
to sell assets from the Fed’s balance sheet, most preferred to initially
raise the federal funds rate, together with the rate of interest on
excess reserves (IOER) and sell assets only later.

It was generally agreed that eventual asset sales should be
“predetermined” and “pre-announced.” Many also argued that assets sales
should be “gradual,” allowing for earlier funds rate hikes.

But many thought that the pace and size of sales could be adjusted
in response to changing economic and financial conditions. The ultimate
goal would be to return to an all-Treasury System Open Market Account
(SOMA).

The minutes also reveal that a majority favors eventual adoption of
a so-called “corridor” system of official rates — with the IOER the
floor rate, the discount rate the ceiling and the funds rate in the
middle.

As previously reported, at the April 26-27 meeting, the FOMC
unanimously kept the federal funds rate target between zero and 25 basis
points and reaffirmed its “extended period” pledge after revising down
its growth forecast and lifting its inflation projection.

Although most Fed officials regarded the recent upsurge in
inflation as “transitory,” minutes of the meeting nevertheless show
heightened concern about inflation — enough to cause some members to
suggest the need for fairly early monetary tightening.

One participant alleged that “excess liquidity” might be causing
commodity speculation, and “many participants reported that an
increasing number of business contacts expressed concerns about rising
cost pressures and were intending, or already attempting, to pass on at
least a portion of these higher costs to their customers in order to
protect profit margins.”

“Many participants had become more concerned about the upside risks
to the inflation outlook, including the possibilities that oil prices
might continue to rise, that there might be greater pass-through of
higher commodity costs into broader price measures, and that elevated
overall inflation caused by higher energy and other commodity prices
could lead to a rise in longer-term inflation expectations,” the minutes
said.

“Participants agreed that monitoring inflation trends and inflation
expectations closely was important in determining whether action would
be needed to prevent a more lasting pickup in the rate of general price
inflation, which would be costly to reverse,” the minutes continue.
“Maintaining well-anchored inflation expectations would depend on the
credibility of the Committee’s commitment to deliver on the price
stability part of its mandate.”

And so when the FOMC got around to discussing monetary, the minutes
disclose that “some participants expressed the view that in the context
of increased inflation risks and roughly balanced risks to economic
growth, the Committee would need to be prepared to begin taking steps
toward less accommodative policy.”

“A few of these participants thought that economic conditions might
warrant action to raise the federal funds rate target or to sell assets
in the SOMA portfolio later this year, but noted that even with such
steps, monetary policy would remain accommodative for some time to
come,” the minutes go on.

“A few members viewed the increase in inflation risks as
suggesting that economic conditions might well evolve in a way that
would warrant the Committee taking steps toward less-accommodative
policy sooner than currently anticipated,” they add.

The minutes report that “a few” still had questions about the
benefits of QE2 but that there was apparently no move to end the program
prematurely, and it was unanimously agreed to let the $600 billion
program of longer-term Treasury security purchases run its course
through the end of June.

As for going beyond QE2, though, the minutes suggest there is a
high bar for any QE3, although members did agree as usual to “regularly
review the size and composition of its securities holdings in light of
incoming information” and to be “prepared to adjust those holdings as
needed to best foster maximum employment and price stability.

“Some members pointed out that there would need to be a significant
change in the economic outlook, or the risks to that outlook, before
another program of asset purchases would be warranted; in their view,
absent such changes, the benefits of additional purchases would be
unlikely to outweigh the costs,” the minutes say.

A year after it first discussed its exit options, the FOMC revisited
the subject, coming to many of the same conclusions. But the committee
was keen to convey that their exit discussion didn’t imply an impending
start of the tightening process.

“Participants noted that the 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,” the minutes say.

The Fed staff gave the committee a presentation on “strategies for
normalizing the stance and conduct of monetary policy over time as the
economy strengthens.”

As the minutes put it, “Normalizing the stance of policy would
entail the withdrawal of the current extraordinary degree of
accommodation at the appropriate time, while normalizing the conduct of
policy would involve draining the large volume of reserve balances in
the banking system and shrinking the overall size of the balance sheet,
as well as returning the SOMA to its historical composition of
essentially only Treasury securities.”

The staff gave the FOMC some “key issues” that it would need to
address:

— First, “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,” the staff told the committee. “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.”

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