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Friday, June 4, 2010

Hoenig on Steps to Normalizing Monetary Policy

In a speech to Bartlesville (OK) Federal Reserve Forum on June 3, Federal Reserve Bank of Kansas City President Thomas Hoenig outlined the steps that the Federal Open Market Committee (FOMC) should take to normalizing monetary policy. First, the Federal Reserve should finish unwinding its extraordinary policy actions it implemented during the financial crisis in the fall of 2008. Hoening states that
As part of this first step, the FOMC would also eliminate its commitment to maintaining “exceptionally low levels of the federal funds rate for an extended period.”(emphasis added)
Second, the FOMC should be prepared to raise the target federal funds rate to 1% by the end of this summer. While this move will maintain a highly accommodative policy stance, it would move the nominal federal funds rate away from zero and make the real federal funds rate less negative.
We would then pause, maintaining the funds rate at 1% while we assess the economic outlook and emerging financial conditions. This would provide time to judge whether and to what degree further policy adjustments are warranted to assure long-run financial equilibrium and stability.
By taking these two actions, Hoenig contends that this “would serve to reduce the likelihood of a buildup of new financial imbalances.”

After taking these two steps, the next move would be to move the federal funds rate target to neutral. This would involve moving the target rate from 1% to 3% reasonably quickly. The final step would be to take the target federal funds rate to between 3.5% and 4.5% as economic growth reaches its long-run potential.

However, if the past is a prologue to the future, the Federal Reserve will take a more gradual approach to raising its target fed funds rate. After the 1991 and 2001 recessions, the Federal Reserve waited 19 and 14 months after the unemployment rate peaked to begin tightening, respectively. Unemployment for this cycle appears to have peaked at 10.1% in October 2009. If the Fed were to follow its previous tightening pattern, the first rate increase would come between December 2010 and late spring 2011. In the previous tightening periods, the Fed has taken about one year to raise the federal funds rate by 200 basis points, or 2%. Having rates at one percent by the end of the summer would be a much more aggressive policy move for the Fed, yet symmetrical to its quick rate reductions and financial market support at the onset of the crisis.

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