The Federal Reserve needs to go back to the drawing board to plan its strategy for winding down its controversial stimulus program, New York Federal Reserve President William Dudley suggested Tuesday.
Dudley called the current exit strategy "stale".
Under that plan, which was hashed out by the central bank in June 2011, the end to stimulus would have gone something like this: First, the Federal Reserve would stop reinvesting principal payments into longer-term Treasury bonds. Next, it would raise short-term rates. Finally, it would sell off its mortgage-backed securities over a three to five year period.
A lot has changed since then though. The Fed launched Operation Twist in September 2011, swapping short-term Treasuries for longer-term bonds. A year later, it unveiled another round of so-called quantitative easing, adding $40 billion in monthly mortgage-backed security purchases. That was followed months later by plans to buy another $45 billion in Treasuries each month.
Fed officials have recently stressed they're prepared to adjust the pace of those purchases either higher or lower, depending on the job market's strength and inflation. Dudley reiterated that point Tuesday.
"Because the outlook is uncertain, I cannot be sure which way -- up or down -- the next change will be," he said in prepared remarks before the Japan Society..
The central bank is aiming for roughly a 6.5% unemployment rate or annual inflation of 2.5%, before it will consider raising short-term interest rates.
Stocks rose to their highest level of the day after Dudley's remarks were released.
Amid its unprecedented stimulus efforts, the Fed's balance sheet has expanded to $3.3 trillion, up from $2.8 trillion in June 2011. Dudley said that has increased some risks for the Fed, citing concerns about market functioning, financial stability and future losses, after years of record profits for the Fed.
There is also a risk that investors could overreact once the Fed starts winding down QE, he said.
"There is a risk is that market participants could overreact to any move in the process of normalization," he said.
Dudley suggested that the Fed change its current plan, to hold the mortgage backed securities it accumulated until maturity. It may be best to to allow those securities "to run off passively over time," he said, noting that selling the securities could lead to a sharp increase in long-term interest rates.
Selling mortgage backed securities at lower prices in the future, could also saddle the Federal Reserve with losses -- an issue that could cause a public relations nightmare. Some Fed insiders believe it could threaten the central bank's independence. St. Louis Fed President James Bullard, for example, has called the potential for future losses a "recipe for political problems."
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