FOMC’s Brainard: Fed may need to raise rates in near future

Lael Brainard, a member of the US Federal Reserve's board of governors and a voting member of its policy committee, has said the Fed might have to further tighten its policy rates in the near future.

"Assuming continued progress" in the economy, it would "likely be appropriate soon to remove additional accommodation, continuing on a gradual path", argued Brainard, who has been one of the most consistently dovish voices on the Federal Open Market Committee (FOMC) in recent years. The US economy "appears to be at a transition", she told an audience at Harvard University yesterday (March 1).

Monetary policy was also "approaching a transition", Brainard said, amid "an improvement in inflation and activity at home and abroad". The recent "drag on domestic activity from abroad" had been "considerable", she said, stemming from perceived risks in major foreign economies, a consequent strengthening of the dollar, financial market anxiety and falling energy prices.

But near-term risks to the US economy from foreign economies appeared to have diminished, Brainard argued. Financial markets seemed confident that Chinese policymakers had "the will and capacity to maintain [China's] exchange rate regime while achieving its growth targets". She did not appear to disagree with this view, although she noted that there was a long-term tension between China's exchange rate and growth policies that "will eventually need to be addressed".

Europe's economic recovery was proving "increasingly resilient", Brainard said. There had been no "significant damage" from recent political or financial market challenges, such as Brexit or worries over Italian banks. There were also recent signs of increasing activity in the Japanese economy.

In the US, "we appear to be closing in on full employment", she said, and there were "welcome signs of progress" in inflation figures. "The contrast with the situation a year ago is sharp", Brainard said, noting that risk spreads on corporate bonds had "moved back down to more normal levels", while orders for capital goods and profit levels had both risen.

While saying that a rate rise might be necessary, she still sounded several notes of caution on the macroeconomic environment.

The nominal neutral real interest rate was still "likely to remain below its historical average, even once it reaches the new longer-run normal level", Brainard said. This would leave much less room for interest rate cuts in the event of a downturn than in earlier eras. She also repeated her concerns that official US labour market surveys might have understated the amount of slack in employment, and therefore failed to highlight the need for extra monetary accommodation.

But Brainard's assessment of the US economy's room for monetary policy tightening, while less firm than some other FOMC members, is still notably stronger than in some of her recent interventions.

In a September 2016 speech, she urged caution over rate rises, noting that the policy rate "cannot be used as readily to respond to downside shocks to aggregate demand as it can to upside shocks". In the same speech, she said policymakers must take account of the "new normal" of low demand and a weaker recent response of inflation to unemployment.

Balance sheet “normalisation”

Brainard also argued yesterday that the Fed needed a new policy regime to shrink its balance sheet, which has considerably expanded as it has pursued quantitative easing. Once the short-term rate was "comfortably distant from its effective lower bound", the Fed could consider two types of strategy regarding its balance sheet, she said.

One would be to "actively deploy the balance sheet as an independent second tool, complementary to the short-term rate". This might be "tempting", Brainard said, but policymakers had "virtually no experience with how such an approach would work in practice away from the effective lower bound".

The other strategy would be a "subordination" policy that would keep the federal funds rate as the main tool of monetary policy, while shrinking the balance sheet in a "gradual predictable way until a "new normal" has been reached". Thereafter, the Fed would increase its balance sheet in line with "trend increases in the demand for currency".

The case for this policy was "straightforward and compelling", Brainard argued. Policymakers had a far better understanding of the use of the federal funds rate. But there might still be "limited circumstances", she said, in which the Fed's balance sheet "might be employed in a manner that is supportive of the short-term rate". These included the immediate aftermath of adverse shocks, and times when the transmission mechanism of rate changes to the real economy was impeded.

There were good reasons to expect that the Fed's "normalised balance sheet" would be "considerably smaller than its current size, but larger than its pre-crisis level", Brainard said. It was, however, "difficult to know with any precision how low reserves can be allowed to drop while still maintaining effective interest rate control".