The second element of the plan would be to announce that at each subsequent meeting the FOMC will, as usual, evaluate incoming data to determine if the interest rate on reserves and the funds rate should rise or not. Monetary policy should be conditional on the state of the economy and the outlook. If the funds rate and interest on excess reserves do not change, the balance sheet would continue to shrink slowly due to run-off and the continuous sales. On the other hand, if the FOMC decides to raise rates by 25 basis points, it would automatically trigger additional asset sales of a specified amount during the intermeeting period. This approach makes the pace of asset sales conditional on the state of the economy, just as the Fed’s interest rate decisions are. If it were necessary to raise the interest rate target more, say, by 50 basis points, because the economy was improving faster and inflation expectations were rising, then the pace of conditional sales would also be doubled during the intermeeting period.

My own view is that except for the period when markets were severely impaired, early in the crisis, the asset purchase programs had, at best, marginal effects on asset returns and economic activity. Given that market functioning has returned to normal, I believe asset sales are unlikely to have a significant impact as market participants’ demand for risk and duration rise.

Others have suggested that we simply rely on raising interest rates and allowing the balance sheet to decline only slowly over time through the natural run-off of maturing securities. In my view, this alternative has several drawbacks. No one knows how fast the Fed might have to raise rates to restrain the huge volume of excess reserves from flowing out of the banking system. Rates might have to rise very quickly and in larger increments than otherwise to offset the accommodative impact of the large balance sheet. This could prove quite disruptive, yet failing to do so could risk much higher inflation levels.

Responding to audience questions afterward, Duke said her opinion is that the Fed shouldn’t begin selling its more than $1 trillion in mortgage-backed securities until after it raises interest rates. The central bank should communicate sales “well in advance to the markets so that markets aren’t surprised,” Duke said.

My own view is that we should begin to sell some of our non-Treasury assets sooner rather than later. Despite recent volatility in markets due to fiscal deficit problems in Europe, financial markets are now functioning much better than they were during the height of the financial crisis, and I believe the Fed could begin to liquidate its positions gradually without market disruption.

If we are to achieve a steady rate environment, it is also important that the Federal Reserve's balance sheet be restored to its pre-crisis size and composition.  Obviously, this requires the careful process of selling the Federal Reserve's $1.3 trillion portfolio of mortgage-backed securities.  Various approaches to this can be identified but most agree that it should be done with the process or time horizon clearly set out for all to see.  I also would suggest it begin at least when the fed funds rate rises above 1 percent or sooner if conditions provide the opportunity

I think [selling assets prior to raising rates is] a legitimate option... My preference for normalizing our balance sheet with more alacrity comes from wanting to reduce that distortion, to the extent that it exists, sooner rather than later.

[Bullard] reiterated that he would favor selling assets before raising rates when the time comes, although he conceded there were other official points of view.

[R]ecognizing the right time to begin normalizing our monetary policy settings is going to be hard, and reasonable people can differ about this. For my part, I will be looking for the time at which economic growth is strong enough and well-enough established to warrant raising our policy rate. It may make sense, however, to begin normalizing our balance sheet in advance of raising rates. Normalizing our balance sheet means reducing its size, but also returning to our traditional Treasury-only asset holdings.

facility. Both would amount to issuing Federal Reserve Bank debt to absorb reserves. While these may be useful as contingency measures, my preference would be to rely primarily on sales of the agency debt and agency-guaranteed mortgage-backed securities that we have purchased over the course of the last year. Such an approach would move us more rapidly to a "Treasuries-only" portfolio, and thus more rapidly reduce the extent to which our asset holdings are distorting the allocation of credit. There is no reason why MBS sales at a steady, moderate, pre-announced pace (as with our purchase program) needs to be disruptive to the markets for those securities. In fact, by adding to the floating private sector supply, it should improve market liquidity, which reportedly has been hampered by our large-scale purchases.

Tag:  Delivery failures

With this caveat in mind, the Federal Reserve Bank of Minneapolis banking studies group has done the following illustrative exercise. The New York Fed has every MBS owned by the Federal Reserve System listed on its Web site. The Minneapolis Fed’s banking studies group obtained data from Bloomberg on the largest quintile of these MBSs by value and used those data to estimate the rate of prepayment on these MBSs over the past year. The group found that this rate of prepayment was sufficiently slow that only half of the mortgages will vanish from the balance sheet every 10 years. This estimate implies that as late as 2030, the Federal Reserve will still be holding something like 250 billion dollars in mortgage-backed securities.

So, the passive approach is a slow approach that will leave the Federal Reserve holding significant amounts of MBSs for many years to come. If the Federal Reserve wants to normalize its balance sheet in the next five, 10, or even 20 years, it needs to supplement the passive approach with an active one. In plain English, it will have to sell mortgage-backed securities...

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Our structure means too that the Federal Reserve can credibly commit to selling its MBSs slowly over time. Along these lines, in testimony before Congress in late March, Chairman Bernanke described how he expected MBS sales to work. He emphasized that the timing of initiating sales, like any other move by the FOMC, would depend on its assessment of economic conditions. But once conditions are right, he suggested that the Federal Reserve could reduce its balance sheet by pre-announcing and then implementing a slow, gradual path of sales.

For a comical discussion of the importance of credible commitments, see entry 5364.

Testing of reverse-repurchase agreements] could be fairly large, because the one question we’re going to have to answer is how fast can we drain a large amount of reserves.  That might affect the timing of when we actually finally act.

Earlier this week, I prepared for this lecture by speaking to some of your undergraduate students by phone. One of the most memorable of them described the Fed's balance sheet as being "really pimped out!" I would not have chosen those words, but, yes, our balance sheet is presently gussied up. We aim to get back to the basics of holding mostly plain vanilla Treasuries—in size needed solely for conducting prudent monetary policy—on the asset side of our balance sheet. And we wish to have banks put their reserves to work, financing growth of the businesses of America, rather than piling those reserves up on the liability side of our balance sheet.

I don’t think we’ve decided yet. There are different views on this. I’m not as reluctant to sell MBS partly because I think we need to get our balance sheet back to more Treasurys and less MBS. I’m not afraid of selling MBS before we raise interest rates. I think the concern that some people have is the potential impact that might have on mortgage rates directly. My view is that if we thought that during the crisis markets were not functioning right and that it made sense to target specific assets to try to control or reduce spreads of various kinds, that may have been relevant in a crisis when markets weren’t functioning. But that’s not true anymore. Markets are functioning pretty well right now. So the ability for us to target specific assets and the consequences they have for prices of those assets is a lot less. Given the market functioning, I don’t anticipate that selling MBS at a reasonable pace, that that’s going to have a tremendous impact on mortgage rates per se.

In response to a question about whether the Fed might start to sell MBS

If necessary, as a means of applying monetary restraint, the Federal Reserve also has the option of redeeming or selling securities. The redemption or sale of securities would have the effect of reducing the size of the Federal Reserve's balance sheet as well as further reducing the quantity of reserves in the banking system. Restoring the size and composition of the balance sheet to a more normal configuration is a longer-term objective of our policies. In any case, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments and on our best judgments about how to meet the Federal Reserve's dual mandate of maximum employment and price stability.

Yes, I think that you're right that shrinking the balance sheet is akin to a monetary tightening...  You sell mortgages on the market, you're going to tend to raise mortgage rates, for example, and that will tend to tighten the housing market and slow the economy.

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...We certainly don't want to hold this stuff 30 years. So the key here, I think, is, when we do come to the point we want to sell assets, is to do it in a gradual and predictable way so it has minimal impact.

Even when we get back to the pre-crisis balance sheet, we'll still be able to manage the short-term interest rate and the federal funds rate, much as we have in the past, so, if the economy needs stimulus, we'll still be able to do that. But we just won't be doing it through the balance sheet.

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But, again, my expectation is that sales would be slow, gradual, announced in advance, and would not create undue market impacts. 

You mentioned adding insult by selling into a weak market. Of course, in a situation where we'd be selling, this would be one where we'd be trying actually to tighten policy because the economy was back on a growth track and we were trying to avoid future inflation risks.  So we wouldn't be doing that in a really weak economy.

During the Q&A session