These are the personal views of Thomas Lam Tai Loong, group chief economist at OSK Group/DMG & Partners:
There is an ongoing division among economists at this time as to when the Federal Reserve might embark on an interest rate hike.
Although it is impossible to answer this question with certainty at this juncture, it is still important to understand the pertinent arguments that set the stage for the eventual normalization in monetary policy.
Broadly, one camp believes that given the significant degree of slack in the economy, even with positive growth, coupled with low underlying inflation (say, around 1%), the initial removal of monetary accommodation might only occur in 2011. Generally, another group reckons that with continued economic recovery and insofar as underlying inflation stabilizes, there is less need for an emergency policy rate environment in the coming months.
Our prevailing Fed policy forecast–we penciled in the first 25-basis-point hike at the Nov. 3, 2010, meeting–is more in line with the second consideration above.
First, we would contend that the state of market conditions, both financial and credit, is an equally crucial determinant of the timing of Fed policy normalization, at least at the outset. If a general indicator of market conditions remains positive (our Mar. 9 Talk Back “US–Ongoing Market Buzz” discusses one possible market indicator, the proprietary Barometer of Market Stress), this could reinforce the notion that an “exceptionally low” or emergency policy rate backdrop is unwarranted.
Second, we anticipate that even with some removal in monetary stimulus, Fed policy, by and large, should hardly be considered restrictive. Hence, the “less loose” policy backdrop could still be conducive to growth.
Essentially, Fed policy in the current environment operates on two fronts:
1) Interest rates (the interest-on-excess-reserves rate, or IOER, and target fed-funds rate).
2) Reserve quantity (the stock of reserves in the banking system).
Therefore, even when the interest rate channel tightens (say, via an increase in the IOER and target funds rate), the still significant stock of reserves in the system should provide some offsetting effects, ensuring that the degree of policy-normalization proceeds gradually and prudently. (Currently, reserves are in excess of $1 trillion, as compared to less than $100 billion prior to the crisis, but will dwindle in subsequent months. Recently, the Treasury Supplementary Financing Program has begun to absorb some reserves.)
The sequence of a Fed policy exit in the coming months could entail some reduction in reserves (via reverse repos, term deposits and measured redemptions in asset holdings) initially followed by the recalibration of the policy statement.
In our judgment, the former activity of reserve drainage might be closely linked to the movement and durability of the spread between the effective fed-funds rate and the upper end of the target or interest-on-reserves rate of 0.25%. If the spread becomes consistently narrower, within 5 to 10 basis points, for instance, it is probably a good indication that the main policy-normalization tool of IOER could be harnessed more efficiently. Ultimately, to be comfortable with the IOER policy lever, the Fed must be confident with the banks’ willingness to arbitrage and/or the ability to manage other counterparties (like the GSEs) to ensure adequate control of the new policy environment. (The current timeline for testing the term-deposit tool is this spring and the planned arrangement for additional counterparties to participate in reverse repos is by the end of second-quarter 2010.)
In sum, while the Fed is cognizant of “what to do” and “how to do it,” the question of “when to do it” will still be contingent on several factors, namely the state of market conditions, the ongoing economic recovery, the stabilization of underlying inflation and the practical readiness of its policy-normalization toolkit.
(The author can be reached at firstname.lastname@example.org.)