The Federal Reserve's balance sheet will probably continue to be used as a monetary policy tool in the future, since interest rates remain low, Federal Reserve Bank of Boston President and CEO Eric S. Rosengren said Wednesday.
"While the extensive use of central bank balance sheets has been a distinguishing feature of the most recent downturn and slow recovery, I see it as quite likely that this tool will be necessary in future economic downturns," Rosengren said in a speech at Bard College, according to prepared text released by the Fed. "Unless productivity growth and demographic trends change, or monetary policymakers set a higher inflation target, the feasible reductions in short-term rates to combat recessions will not be sufficient. Thus, monetary policymakers are likely to need to use balance-sheet tools."
The Fed should also "adopt balance sheet exit strategies that reinforce the primacy of interest rate policy," he said, noting he would prefer starting "earlier" and moving slowly.
He specified his plan calls for "retiring only a small percentage of maturing securities," at first "and then very gradually shrinking the volume of the securities being reinvested." The balance sheet reductions would be independent of tightening short-term interest rates.
A gradual reduction, he said, "implies very little reduction in the degree of monetary stimulus coming from the U.S. central bank's balance sheet. This, in turn, will allow policymakers to focus on gradual increases in the federal funds rate target as the primary mechanism for normalizing monetary policy and calibrating the economy."
Large-scale asset purchases may be needed in future recessions, Rosengren said, as low inflation, little growth in productivity and slow growth in population keeps short-term interest rates at historically low levels, even when the monetary policy is normalized completely.
In its Summary of Economic Projections (SEP), the median forecast was a 3% federal funds rate. In most downturns, the fed has cut "interest rates by substantially more than 300 basis points. So a 3 percent federal funds rate would imply a high probability that short-term interest rates would have to be lowered again to zero in response to future recessions. As a result, the central bank may need to again deploy its balance sheet to augment traditional policy, spur economic activity, and achieve its mandates from Congress associated with employment and price stability," he said.
If the Fed needs to use asset purchases in future recessions, it will again face balance sheet concerns. "So if done appropriately, the exit from the current large balance sheet can serve as an important 'playbook' for future recovery periods should it prove necessary."
While short-term interest rates will remain the preferred method of influencing short-term rates, Rosengren noted.
