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Two regional Federal Reserve officials said Monday that a faster withdrawal from the central bank’s bond purchase program could give it more leeway in deciding when to raise interest rates.
The discussion of how fast to end the Fed’s $120 billion monthly bond purchase program is only just beginning, but policymakers should keep in mind how it affects the debate that will follow it over interest rates.
“Creating optionality for the committee will be really useful and that will be part of the taper debate as we think about how much signaling we are doing about future rate policy,” St. Louis Fed president James Bullard said during a virtual event organized by the Official Monetary and Financial Institutions Forum and the Philadelphia Fed.
The policymakers highlighted some of the major questions Fed officials will have to grapple with as they work through an early test of the central bank’s new strategic framework at a time when inflation is coming in strong and the labor market recovery is weaker than expected.
Dallas Fed president Robert Kaplan noted the framework does not mention bond purchases, which were intended to lower interest rates and boost demand. Now that demand is up and many of the major factors limiting economic growth are linked to supply imbalances, “moderating that sooner than later” might give the Fed more flexibility over the rate discussion.
Under the new approach, officials are willing to overshoot the Fed’s 2 percent inflation target for “some time” in order to achieve average 2 percent inflation and maximum employment. Policymakers will need to decide how much inflation they are comfortable with and for how long they would tolerate an overshoot of the Fed’s target before adjusting monetary policy, Bullard said.
“What’s the timeframe for that and what’s the magnitude of that?” he said. “I think that’s a healthy debate to have.”
Fresh economic projections released after last week’s policy meeting showed 11 of 18 Fed policymakers are penciling in at least two quarter-percentage-point rate increases by the end of 2023, a shift from March, when a clear majority of policymakers favored no change to interest rates until 2024.
The tilt to a faster expected start to interest rate increases caught markets by surprise. Kaplan said it was a reaction to an economic outlook that took a sharp turn between December and June.
As of December, the path of the coronavirus pandemic remained uncertain, Kaplan said. “When we got to March, it was clearer that we were going to get the pandemic under control,” he said.
And by June, the outlook received a “big upgrade” that made the core of officials expect rate increases in 2023 instead of 2024. “What you are seeing … is monetary policymakers simply reacting to the dramatically improved economic outlook.”
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