Cape Town — Friday NY Fed President Dudley made his first comments on rates and the rate cycle since December 2014. Noting really new here — Dudley largely dismisses and doesn’t buy into the “secular stagflation” argument; he views raising rates too soon as a mistake. Dudley believes, like I, that normalization of monetary policy sound happen gradually.
Dudley says monetary policy cannot be put on autopilot guided only by a fixed policy rule. He points out long rates are too low.
In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity market’s valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.
My view — unlikely to see too harsh of a hike with the weak recovery we’re in. Dudley and Yellen both preparing the market for the inevitable hike. We’ll see just how well hedged market participants are. Personally believe there’s a lot of large one way directional bets to try and cash in before the coming hike cycle is viewed as less favorable to current asset prices.
No preset course in hiking. Dudley isn’t set on using the “taylor” rule — which, in my view, is a good idea NOT to. Stoping reinvest and drain excess reserves RRP and runoff. We don’t want the reserves anyways (stricter bank leverage ratio requirements). ER’s are deposit liability for large financial institutions. With reserve draining the overall balance sheet of the banking system levers down — hence fewer reserve assets and fewer liabilities.
Without draining excess reserves the Fed cannot achieve a functioning fed funds market. Institutions not eligible for IOR specifically GSEs, FHLBs are primary sellers of fed funds. Depository institutions don’t really have any incentive to lend at rates lower than IOR.
Foreign banks operating in the US do not have to pay the FDIC fees which explains why they are large holders of reserves. GSE’s and FHLBs have an incentive to lend into the fed funds market, even though the current rate is lower than IOR.
ZIRP won’t be around forever. For now too soon to tell, with the benefit of hindsight, if it’s a policy mistake for not tightening monetary policy aggressively enough — as hawks like Richard Fisher assert. My advice would be run it hot, cease reinvestment of securities principal allowing the Fed’s balance sheet to shrink as securities matured, then we can see if we’re all ready for RRP and the much talked about “lift off.”