One other issue that has been getting some attention is what we’re planning on doing with our sizable balance sheet, which swelled to some $4 trillion after three rounds of quantitative easing. We have a ways to go before we start to unwind it, and it won’t happen until normalization of the funds rate is well under way. After that, our plan is to shrink the balance sheet “organically,” if you will, through the maturation of the assets. It’s going to take at least six years to get the balance sheet back to normal, which is in keeping with the overall approach of removing accommodation gradually.

Asked how he would reduce the Fed’s vast bond holdings, Mr. Bernanke, no longer the Fed’s chairman, responded, “Fortunately, I don’t have to.”

As for the balance sheet, there’s a ways to go before we start to unwind it, and it won’t happen until normalization of the funds rate is well under way. After that, our plan is to shrink the balance sheet “organically,” through the maturation of the assets. It’s going to take at least six years to get the balance sheet back to normal, which is in keeping with the overall approach to removing accommodation gradually.

A central bank can use its balance sheet to alter the allocation of credit in the economy. By lending to or buying the securities of private sector entities, central bank credit allocation can cause more resources to flow to those segments of the economy than would otherwise be the case. This deprives other sectors of resources, however, and may distort economic activity in a way that is unproductive. Importantly though, I would not characterize central bank credit allocation as monetary policy, but rather as fiscal policy. As a result, I believe it is appropriate for such actions to be taken only by elected branches of government, not by the central bank.

This is why I have dissented on FOMC decisions to purchase securities backed by home mortgages.

In discussing why I view the framework as effective, it’s helpful to start by explaining what it means for the tools to work well. I think about this issue through three lenses: interest rate control, avoiding unintended impact on the structure of the financial system, and avoiding financial instability...

It is of great importance that the public is confident that the federal funds rate will be, on average over time, within the target range set forth by the FOMC, and that other money market rates will continue to move closely with changes in the federal funds rate...

A second lens for evaluating the operational framework is the extent to which it avoids creating incentives that might result in undesirable changes in the structure of the financial system. This means that the framework shouldn’t have lasting unintended effects on how people invest their money or on how financial institutions interact with each other...

In particular, the framework shouldn’t create a risk that, in times of stress, money market lenders will rapidly disintermediate their usual counterparties and come to the Federal Reserve instead, such as through the ON RRP facility.

We don’t know precisely how the economy will evolve; this argues against deciding to end reinvestments after some particular period of time has elapsed. Instead, because some policy accommodation is provided via the balance sheet, it would seem better to base the decision about reinvestments on economic conditions and the outlook, just as we do with the funds rate path. Indeed, the economic conditions and outlook that would support reducing the degree of monetary accommodation by gradually raising the fed funds rate would also tend to support slowly reducing the size of the balance sheet, which would result when reinvestments end. Thus, in my view, the level of the fed funds rate might be used as a guide to when to end reinvestments – in this case, both our fed funds rate path and our balance-sheet policy would be data dependent. I would be comfortable ending reinvestments after we have a few more funds rate increases under our belt, perhaps when the funds rate has reached 1 percent or so. This is my interpretation of “well underway,” but as Chair Yellen indicated in her December press briefing, the FOMC has not given further guidance on this.

The Committee has indicated that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively. But that statement leaves open the question of when we should begin to reduce the size of our balance sheet. Because the tools I mentioned earlier--the payment of interest on reserve balances and the overnight reverse repurchase facility--can be used to raise the federal funds rate independent of the size of the balance sheet, we have the flexibility to adjust the size of our balance sheet at the appropriate time. With the federal funds rate still quite low and expected to rise only gradually, I think there is some benefit to maintaining a larger balance sheet for a time.

I also believe that continuing reinvestment until the federal funds rate reaches a higher level makes sense. We want to ensure that we have the ability to respond to adverse shocks by easing monetary policy by lowering the policy rate. Having more “dry powder” in the form of higher short-term interest rates seems more desirable than less dry powder and a smaller balance sheet.

Now the words “well underway” in the FOMC statement are vague—what does that mean in terms of the level of the federal funds rate? Reiterating the disclaimer that I am speaking for myself, my view is that we should not set a numerical tripwire for ending reinvestment. If the economy were growing very quickly and the risks of an early return to the zero lower bound for the federal funds rate were deemed to be low, then I could see ending reinvestment at a relatively low federal funds rate. In contrast, if the economy lacked forward momentum and the risks of a return to the zero lower bound were judged to be considerably higher, I would want to continue reinvestment until the federal funds rate was higher. Consistent with the general principles I mentioned before, the evolution of the overall monetary policy stance—both interest rate decisions and balance sheet developments—should be data dependent.

We have made clear in our communication—and let me reiterate—that we still have a ways to go before we start to unwind it. For the time being, we’re maintaining its size through reinvestment, so that the first steps in removing monetary accommodation occur slowly and gradually, via the funds rate only. This will continue until normalization of the funds rate is well under way. After that, our plan is to shrink the balance sheet “organically,” if you will, through the maturation of the assets. It’s likely going to take at least six years to get the balance sheet back to normal, which is in keeping with the overall approach to removing accommodation gradually.

WINKLER: So you mentioned the balance sheet earlier in this discussion, which is now more than $4 trillion. The Fed has said that in the long run it should be reduced to the smallest level consistent with, "the efficient implementation of monetary policy." So what would say is the new normal for the balance sheet post crisis?

  DUDLEY: Well that statement was I think is a little bit deliberately vague because I don't think we really know what monetary policy regime for sure is going to be the right monetary regime in the long run. We're going to get a lot of information over the next few years conducting monetary policy with a large balance sheet, relying on the interest on excess reserves as the main tool of monetary policy. If that turns out to be fabulously successful it's possible that we could run monetary policy with what's called a floor system where we set an interest rate that actually has essentially the magnet-setting rates in money markets broadly. Or we could decide that this isn't so - this doesn't work so well, and we want to go back to the system that we had before the crisis, which was just a very small amount of reserves in the system with the federal funds rate balanced by the Federal Reserve adding and subtracting reserves to keep things in balance. I think my own view is it's too soon to make that call. That call will be made by future committees.

And my own personal opinion is let's see how things go. Let's learn. And as we learn then we can figure out what regime is right. And then that will determine the size of the balance sheet. Now what the principals are basically saying though, whatever regime we pick we're going to want to keep this balance sheet as small as possible, consistent with that regime being effective.

So we've indicated that the main tool we will use is the interest rate we pay on overnight reserves. The overnight RRP facility that you refer to I think of is a backup tool that will be used to help us control the federal funds rate, to improve our control over the federal funds rate. I think it's a very useful and effective tool. We have gleaned that from the initial testing that we have done.

But as you mention, we do have concerns about allowing that facility to become too large or to play too prominent a role and for precisely the reason that you gave: If stresses were to develop in the market, in effect it provides a safe haven that could cause flight from lending to other participants in the money markets.

So two tools that we can use and are discussing to control those risks, one would be to maintain relatively large spread between the interest rate we pay on overnight reverse RPs, and the interest rate on excess reserves, the larger that's spread, the less use that facility will be. Also, we can contemplate limits on the extent to which it can be used, either aggregate limits or limits that would apply to individual participants, and all of that is figuring into our discussions.

Central bank actions constitute monetary policy if they alter the quantity of its monetary liabilities, often referred to as high-powered money. Central bank actions constitute credit policy if they alter the composition of its portfolio — by lending, for example — but do not affect the outstanding amount of monetary liabilities.

…

I’ll close with a reminder that establishing credible limits to central bank intervention in credit markets is critical to central banks’ core monetary policy mission. Entanglement in the distributional politics of credit allocation inevitably threatens the delicate equilibrium underlying central bank independence, which has been so essential to monetary stability. The fallout from the 2008 crisis vividly illustrates the risks to that equilibrium. The breakdown of that equilibrium in the 1970s provides vivid lessons in the dangers of credit allocation. Not only did Fed policymakers need to resist political pressure to lower unemployment, they also had their hands full resisting pressure to buy federal agency debt. The disastrous results for inflation are well known. Less well known is that by 1977, the Fed owned $117 million in debt issued by Washington, D.C.’s transit authority — with the bizarre result that the Fed wound up financing the construction of the Washington Metro.

There are several reasons motivating our interest in developing {an overnight fixed-rate reverse repo} facility. First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates. .. These reverse repos would be available to an expanded set of counterparties that includes many of the money market lenders who are ineligible to earn the interest on excess reserves (IOER), such as GSEs and a number of money market funds. Depending on the facility rate, these lenders who cannot earn the IOER rate might get a better rate by investing in the overnight RRPs compared to lending to banks or to broker dealers. This competitive effect could, in and of itself, put a stronger floor on money market rates.

Second, this new facility is also likely to reduce the volatility of short-term interest rates. If a lender that cannot earn the IOER rate has an unexpectedly large amount of funds to invest, this lender currently may have to accept an unusually low interest rate. But with the overnight reverse repo facility in place, this lender could lend as much funds as desired to the facility at a fixed rate and this should reduce the downward pressure on money market rates. By tightening control and reducing the volatility of short-term rates, such a facility should reassure investors that the Federal Reserve has sufficient tools to manage monetary policy effectively even with a very large balance sheet.

In coming months we will test the facility with two goals in mind. First, we want to be assured that there are no glitches operationally with somewhat higher transaction volumes than in previous tests, that we can accept cash from a larger array of counterparties, post collateral in the tri-party repo system and reverse the transactions each day smoothly. Second, while the limited size of the operations during this exercise will prevent the operations from having a significant impact on market rates, we will observe how the facility impacts individual investor demand relative to other market rates. Additionally, we can see how sensitive that demand is to changes in market conditions such as quarter-end that increase the demand for safe assets. These observations will give us some insight into how the facility could affect the entire constellation of money market rates. Only by testing and learning will we be able to assess how best to use the facility.

There are several reasons motivating our interest in developing {an overnight fixed-rate reverse repo} facility. First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates. .. These reverse repos would be available to an expanded set of counterparties that includes many of the money market lenders who are ineligible to earn the interest on excess reserves (IOER), such as GSEs and a number of money market funds. Depending on the facility rate, these lenders who cannot earn the IOER rate might get a better rate by investing in the overnight RRPs compared to lending to banks or to broker dealers. This competitive effect could, in and of itself, put a stronger floor on money market rates.

Second, this new facility is also likely to reduce the volatility of short-term interest rates. If a lender that cannot earn the IOER rate has an unexpectedly large amount of funds to invest, this lender currently may have to accept an unusually low interest rate. But with the overnight reverse repo facility in place, this lender could lend as much funds as desired to the facility at a fixed rate and this should reduce the downward pressure on money market rates. By tightening control and reducing the volatility of short-term rates, such a facility should reassure investors that the Federal Reserve has sufficient tools to manage monetary policy effectively even with a very large balance sheet.

…

In coming months we will test the facility with two goals in mind. First, we want to be assured that there are no glitches operationally with somewhat higher transaction volumes than in previous tests, that we can accept cash from a larger array of counterparties, post collateral in the tri-party repo system and reverse the transactions each day smoothly. Second, while the limited size of the operations during this exercise will prevent the operations from having a significant impact on market rates, we will observe how the facility impacts individual investor demand relative to other market rates. Additionally, we can see how sensitive that demand is to changes in market conditions such as quarter-end that increase the demand for safe assets. These observations will give us some insight into how the facility could affect the entire constellation of money market rates. Only by testing and learning will we be able to assess how best to use the facility.

But I do believe that big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.

...

My personal feeling is that you don’t walk up to a lion and flinch.