By Brai Odion-Esene and Claudia Hirsch

NEW YORK (MNI) – Philadelphia Federal Reserve President Charles
Plosser proposed Friday that the Fed’s exit strategy from its monetary
stimulus should involve raising rates and shrinking its balance sheet
“concurrently.”

He also assured that the risk posed by tragic events in Japan and
higher prices due to turmoil in the Middle East “is small and short
term.”

In remarks prepared for delivery at a Shadow Open Market Committee
event in New York, Plosser — who is a voter on the Federal Open Market
Committee this year — said the pace of asset sales should be tied to
“the pace and size of interest rate increases.”

“The apparent strengthening of the U.S. economy suggests it is
prudent for policymakers to develop a strategy for the normalization of
monetary policy,” he said. “Today I want to suggest such a strategy.”

The first element of Plosser’s proposed plan to exit and reverse
monetary policy would be to move away from the zero bound and stop the
reinvesting program, allowing 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,” he said.

As part of the strategy, Plosser continued, between each FOMC
meeting would be an announcement by the Fed that as assets are allowed
to run off — as they mature or are prepaid — it 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,” he said.

Plosser stressed that any actions taken should be conditional on
the state of the economy.

“Monetary policy should be conditional on the state of the economy
and the outlook … . This approach makes the pace of asset sales
conditional on the state of the economy, just as the Fed’s interest rate
decisions are,” he said.

In the earlier part of his speech, Plosser had provided a more
bullish outlook for the U.S. economy, and said if this forecast is
broadly accurate, “then monetary policy will have to reverse course in
the not-too-distant future and begin to remove the massive amount of
accommodation it has supplied to the economy.”

He went on to warn that a failure to do so in a timely manner could
have “serious consequences” for inflation and economic stability in the
future.

Plosser acknowledged that in designing an effective exit strategy,
“We must start by deciding what the operating framework should look like
at the end of the process.”

He added that a systematic approach should adopted towards crafting
an exit strategy, as it would reduce uncertainty by offering a degree of
commitment by policymakers to the exit strategy.

On his preferred elements that should be present in any operating
framework, Plosser put forward four:

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. “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,” he said;

The Fed should also restructure the balance sheet in terms of its
composition and maturity structure, he said, adding that “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”;

Finally, Plosser urged the adoption of an explicit inflation
objective, which he argued would contribute to the effectiveness of
policy and the policy framework and any plan for normalization.

Plosser’s comments also made it clear that he does not think asset
sales by the Fed would harm the market, pointing out “given market
functioning has returned to normal, I believe asset sales are unlikely
to have a significant impact as market participants’ demand for risk and
duration rise.”

He also stressed during the audience q&a that the run off rate of
Fed MBS assets would be “smooth.”

As for his comments on the U.S. economy, referenced earlier,
Plosser noted that “noting that the economy has gained significant
strength and momentum since late last summer and seems to be on a much
firmer foundation going forward.”

Consumer spending continues to expand at a reasonably robust pace,
he said, while business investment — “particularly on equipment and
software” — continues to support overall growth.

On the continued weakness in the residential and commercial real
estate sectors, Plosser said they will not prevent a broader economic
recovery.

He also sought to downplay the potential risks posed by higher oil
prices and recent events in Japan.

“I believe this risk is small and short term, assuming Japan is
able to stabilize its nuclear reactors and political unrest in the
Middle East does not dramatically disrupt Saudi Arabia, the region’s
largest oil producer,” Plosser said.

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