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COLUMN-If you like the present you’ll love the future of monetary policy: James Saft

(The opinions expressed here are those of the author, a columnist for Reuters)

By James Saft

Feb 23 (Reuters) - U.S. interest rates will rise but the future of monetary policy may look a lot more like the present than the pre-crisis past.

Not only has the world changed, but the occupant of the White House has changed, and that will change, perhaps substantially, the lineup and outlook of the Federal Reserve.

After the Fed has tightened two or perhaps three times this year, its ability and will to continue to hike, or to shrink its massive balance sheet will be materially constrained.

The minutes of the January rate-setting meeting, released Wednesday, gave the impression that a March hike was in play more as a matter of form than reality. What’s more there was little by way of discussion about the $4.5 trillion balance sheet of bonds the Fed purchased to influence the level of interest rates, credit availability and longer-term financing costs.

“It was noted that the downward pressure on longer-term interest rates exerted by the Federal Reserve’s asset holdings was expected to diminish in the years ahead in light of an anticipated gradual reduction in the size and duration of the Federal Reserve’s balance sheet,” the minutes said.

“Finally, the view that gradual increases in the federal funds rate were likely to be appropriate also reflected the assessment that the neutral real rate - defined as the real interest rate that is neither expansionary nor contractionary when the economy is operating at or near its potential - was currently quite low and was likely to rise only slowly over time.”

In other words, we don’t really want to talk about how we will run the balance sheet down any time soon and it kind of doesn’t matter anyway. The Fed needn’t be in a hurry to bring its balance sheet down to pre-crisis norms, but were it to be, it might be in a fix anyway.

San Francisco Fed President John Williams, who has become something of a structural dove, argues that the equilibrium interest rate, r-star, the rate at which the economy is in balance between growth and inflation, has fallen, making it harder to manage the economy, and harder to avoid financial upsets.

“In a low r-star world, what were once called ‘extraordinary’ policies - like zero or negative interest rates, forward guidance, and balance sheet policies - are likely to become the norm,” Williams wrote in a Tuesday note. (http://www.frbsf.org/economic-research/publications/economic-letter/2017/february/three-questions-on-r-star-natural-rate-of-interest/?utm_source=frbsf-home-economic-letter-title&utm_medium=frbsf&utm_campaign=economic-letter)


Williams’ analysis cuts both ways: it will be harder to get rates back to historic norms and lighten the balance sheet, but doing so may have disproportionate utility, as it gives the Fed ammunition with which to fight the next downturn in the cycle.

With the upcoming resignation of Daniel Tarullo, Trump will have three appointments to make to the Fed’s board of governors. He will also get to appoint the chair sometime in the next year, either retaining Janet Yellen or replacing her. If Yellen is replaced as chair but elects not to remain on the board, an option at her disposal, Trump would get another slot. Fed Vice Chair Stanley Fischer might also head for the door.

While Trump campaigned “against” easy Fed policy, in somewhat the same way he campaigned against the press, now that he can, via appointments, influence it you can expect he will and that appointees will see the wisdom of keeping the financing costs of the Trump experiment lower rather than higher.

That’s not to say Trump Fed appointees won’t fight inflation - they will - but given that there are strong arguments for keeping rates low and the balance sheet large, you can see how he would find candidates who find these arguments compelling.

Allowing bonds to mature is a tightening; Yellen has estimated that allowing the $177 billion of maturing Treasuries this year to run off would be about the same as raising rates by a half a percentage point.

Noting that $425 billion of Treasuries mature next year and another $350 billion or so do in 2019, Marc Chandler of Brown Brothers Harriman argues that “the tightening will swamp the use of the fed funds target range as the primary tool of monetary policy.”

Extraordinary monetary policy may only become slightly less extraordinary.

(Editing by James Dalgleish) )