A Good Exit Strategy Proposed by Philadelphia Fed President Plosser

Last Friday in New York, Charles Plosser, President of the Philadelphia Fed, proposed an exit strategy for the Fed. It’s the first explicit exit strategy to be put forth by a member of the FOMC, so it deserves careful consideration and discussion.

Previous statements about exits by Fed officials simply listed the tools that could be used in an exit strategy, but did not actually put forth an exit strategy. In contrast, President Plosser describes a specific strategy.

Two things are very attractive about strategy. First, it aims is to return monetary policy to one in which the federal funds rate is determined by the supply and demand for reserves. This of course requires that the Fed bring down the enormous supply of reserve balances on its balance to a level closer to a quantity demanded by banks at a positive interest rate. Reserves were $26 billion on September 10, 2008 when the fund rate was 2 percent just before the panic, which gives an order of magnitude of where reserves should go. Plosser assumes $50 billion, which seems reasonable to me. But reserve balances will be around $1,500 billion by the time QEII is over, so it’s a long way down.

The second attractive feature of the exit strategy is that the path of reduction in reserve balances is tied to future movements of the federal funds rate. It is thus much like an exit rule, or a contingency plan, which both preserves flexibility and creates predictability. The exit rule would reduce reserves by $125 billion for each 25 basis point increase in the funds rate plus another $50 billion at each FOMC meeting. After 10 meetings $1,450 billion would be removed (the contingency plan starts at the second meeting) bringing reserves to $50 billion.

This chart, drawn from data in his speech, shows how the strategy would work if the Fed increased the federal funds rate by 25 basis points for ten consecutive meetings. Of course an advantage of this strategy is that the pace of reserve drawdown is tied to the funds rate—if the funds rate rises more quickly reserves will come down more quickly.

The strategy is very close to one I recommended a year ago in testimony, “An Exit Rule for Monetary Policy,” prepared for a Congressional hearing at the House Financial Services Committee. I suggested $100 billion per 25 basis points with no constant amount, but that was before QEII when reserve balances were much lower. I argued that such a strategy would reduce risks in the markets. With increased predictability about policy, banks could better manage their own balance sheets and the price discovery process would be much smoother as funds traders and other market participants could better anticipate what the Fed would do, a view which was supported by Peter Fisher (head of the New York Fed trading desk in the 1990s), who I consulted about the idea at the time.

Of course the New York Fed trading desk should have some discretion about how to execute the FOMC’s directive if such a strategy is adopted. I hope it is.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

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