NEW YORK (MNI) – The following is the second part of the text of a
speech by Charles Plosser, president of the Federal Reserve Bank of
Philidelphia to the Shadow Open Market Committee in New York on the
framework for long-run monetary policy, March 25:

The Monetary Policy Operating Framework After Exit Continued:

The second element of the environment follows from the first. To
ensure that the funds rate constitutes a viable policy instrument and
thus is above the interest rate on reserves, the volume of reserves in
the banking system must shrink to the point where the demand for
reserves is consistent with the targeted funds rate. This will require
a significant reduction in the size of the Fed’s balance sheet, with
reserve balances falling by $1.4 trillion to $1.5 trillion to about $50
billion.

The third characteristic of my preferred operating environment has
to do with the composition of the Fed’s assets and in particular the
System Open Market Account, or SOMA, portfolio. I believe this
portfolio should consist predominantly of U.S. Treasury securities
concentrated in short-term issues, similar to its composition prior to
the crisis. At that time, about 90 percent of the SOMA assets were
Treasuries, of which about 35 percent were Treasury bills. Currently,
only about 60 percent of the portfolio is in Treasuries, while around 40
percent is housing-related assets, such as mortgage-backed securities
(MBS). Moreover, Treasury bills are less than 2 percent of the Treasury
securities in the portfolio. Thus, the exit plan must contemplate a
significant restructuring of the balance sheet in terms of its
composition and average maturity.

Fourth, my preferred operating environment would make explicit the
Fed’s commitment to a numerical inflation objective, a proposal I have
made many times. Numerical inflation objectives are fairly common
among major central banks around the world and many academics and
students of central banking regard adopting such an objective as best
practice. I believe it is time for the Federal Reserve to adopt this
best practice and clearly announce a numerical inflation objective in
support of our dual mandate. This would be particularly valuable as we
exit our accommodative stance. Since our large balance sheet poses
significant risks for inflation down the road, an explicit commitment to
a low and stable inflation rate would help reassure the public that we
will exit in a way that is consistent with that goal. This would also
help keep expectations of inflation well anchored.

To summarize, my preferred operating environment would re-establish
the federal funds rate as the primary instrument of monetary policy;
shrink the balance sheet and reserves to levels that make the federal
funds rate an effective policy tool; and restructure the balance sheet
in terms of its composition and maturity structure. Adopting an
explicit inflation objective would contribute to the effectiveness of
policy and the policy framework and any plan for normalization.

A Proposed Exit Plan

Now that I have described where I think our policy framework should
be, the next step is to lay out an exit plan that takes us there. As I
argued at the outset, it is important to have a plan. The plan must be
communicated to the public and markets in a way that reduces
uncertainty, and it should explain how decisions will depend on economic
conditions, just like other monetary policy decisions.

Economists have recognized that any exit plan will use several
policy tools, including raising interest rates and shrinking the balance
sheet. Some would start with raising interest rates; some would begin
by shrinking the balance sheet; others would do both.

My proposed strategy involves raising rates and shrinking the
balance sheet concurrently and tying the pace of asset sales to the pace
and size of interest rate increases.

The first element of the plan to exit and normalize policy would be
to move away from the zero bound and stop the reinvesting program and
allow securities to run off as they mature. Thus, we would raise the
interest paid on reserves from 25 basis points to 50 basis points and
seek to achieve a funds rate of 50 basis points rather than the current
range of 0 to 25 basis points. We would also announce that between
each FOMC meeting, in addition to allowing assets to run off as they
mature or are prepaid, we would sell an additional specified amount of
assets. These “continuous sales,” plus the natural run-off, imply that
the balance sheet, and thus reserves, would gradually shrink between
each FOMC meeting on an ongoing basis.

The second element of the plan would be to announce that at each
subsequent meeting the FOMC will, as usual, evaluate incoming data to
determine if the interest rate on reserves and the funds rate should
rise or not. Monetary policy should be conditional on the state of the
economy and the outlook. If the funds rate and interest on excess
reserves do not change, the balance sheet would continue to shrink
slowly due to run-off and the continuous sales. On the other hand, if
the FOMC decides to raise rates by 25 basis points, it would
automatically trigger additional asset sales of a specified amount
during the intermeeting period. This approach makes the pace of asset
sales conditional on the state of the economy, just as the Fed’s
interest rate decisions are. If it were necessary to raise the interest
rate target more, say, by 50 basis points, because the economy was
improving faster and inflation expectations were rising, then the pace
of conditional sales would also be doubled during the intermeeting
period.

The third element of the exit plan must address the composition of
the Fed’s portfolio. If we are to return to an all-Treasuries
portfolio, then asset sales, particularly in the early part of the
program, must be concentrated in MBS.

Examples of the Exit Strategy

What are the consequences of this strategy? In order to make the
proposal concrete, first, let’s assume that excess reserves need to
shrink by about $1.4 to $1.5 trillion in order to permit the federal
funds rate to be reliably above the interest rate paid on reserves.
Second, let’s assume that once asset purchases end and the practice of
reinvesting proceeds from maturing or prepaid assets stops, the balance
sheet will begin to contract by about $20 billion a month, or by about
$30 billion between FOMC meetings, which occur about every six weeks.
This will vary somewhat over time and with the level of interest rates,
but that will make little difference in the overall thrust of the plan.
Third, let’s consider continuous sales of $20 billion in assets between
each FOMC meeting. This pace of continuous sales plus the natural
run-off imply that the balance sheet, and thus reserves, would shrink by
about $50 billion between each FOMC meeting on an ongoing basis.

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