The minutes of the Fed's April 26-27 policy meeting gave a little more detail about the internal debate over when and how to begin unwinding currently very accommodative policy. Much has already been discussed by Chairman Bernanke at his first post-FOMC press conference and in speeches by some District Bank presidents. There was little dissention regarding the current status of policy although some indicated they saw little benefit from additional quantitative easing but so little reason to not finish QE2 since completion is close. Regarding inflation, most saw the recent effects of recent oil price hikes as transitory. Most within the FOMC see the fed funds rate as the preferred active tool for tightening but for now most see an end to reinvestment of pay down on mortgage-backed securities and agency debt as the first step in tightening. For the long-term, most are arguing for a "corridor" system of fed interest rates with interest on excess reserves at the bottom, the discount rate at the top, and the fed funds rate in the middle. For the long term, the FOMC wants to return the balance sheet to Treasuries only.
Staff economists helped to set the stage for the policy debate by giving a presentation on strategies for normalizing the stance and conduct of monetary policy over time as the economy strengthens. The staff differentiated between normalizing the stance of policy and the conduct of policy.
"Normalizing the stance of policy would entail the withdrawal of the current extraordinary degree of accommodation at the appropriate time, while normalizing the conduct of policy would involve draining the large volume of reserve balances in the banking system and shrinking the overall size of the balance sheet, as well as returning the SOMA [System Open Market Account] to its historical composition of essentially only Treasury securities."
For the first, the Fed will need to return to a neutral stance from the current accommodative stance. For the second, that means shrinking the balance sheet back to a level reflecting slow, long-term growth and using the fed funds rate as the primary policy tool.
But along the way, the Fed has to choose whether to unwind initially more with rate increases or balance sheet shrinkage or a combination of both.
"The first key issue was the extent to which the Committee would want to tighten policy, at the appropriate time, by increasing short-term interest rates, by decreasing its holdings of longer-term securities, or both. Because the two policies would restrain economic activity by tightening financial conditions, they could be combined in various ways to achieve similar outcomes. For example, in principle, the Committee could accomplish essentially the same degree of monetary tightening by selling assets sooner and faster but raising the target for the federal funds rate later and more slowly, or by selling assets later and more slowly but increasing the federal funds rate target sooner and faster."
The FOMC agreed on several principles to guide normalization of policy. First, the pace and sequencing of the policy steps would be driven by the Committee's monetary policy objectives for maximum employment and price stability. Second, in the intermediate term, the balance sheet would be would be reduced so that implementation of monetary policy would be through management of the fed funds rate instead of size or balance sheet composition. Third, the balance sheet would be returned to Treasuries only. And fourth, asset sales would be communicated to the public in advance.
As already noted during the chairman's press conference and in the earlier release of Fed forecasts, FOMC participants downgraded their forecast for GDP growth in 2011 while bumping up the 2011 inflation forecast. Nonetheless, members decided to indicate that the economic recovery was proceeding at a moderate pace and that overall conditions in the labor market were gradually improving.
Today's minutes primarily add depth to the debate over conduct of monetary policy over the next few years. While the Fed likely will raise interest rates not long into 2012 if not a little sooner, it will take years for the balance sheet to be returned to normal.