Fed officials: Faster bond taper could provide leeway on interest rates

By Howard Schneider and Jonnelle Marte

WASHINGTON (Reuters) -The early debate over how the Federal Reserve could begin to withdraw some of its massive support for the economy was on full display on Monday when two U.S. central bank officials discussed how the playbook used after the 2007-2009 recession may not apply this time.

The conversation over how fast to end the Fed's $120 billion in monthly bond purchases is just beginning, but policymakers said a faster withdrawal from the program could give the central bank more leeway in deciding when to raise interest rates.

"Creating optionality for the committee will be really useful and that will be part of the taper debate as we think about how much signaling we are doing about future rate policy," St. Louis Fed President James Bullard said during a virtual event organized by the Official Monetary and Financial Institutions Forum and the Philadelphia Fed.

Bullard and Dallas Fed President Robert Kaplan, who spoke on the same panel, highlighted some of the major questions Fed officials will have to grapple with as they work through an early test of the central bank's new strategic framework at a time when inflation is coming in strong and the labor market recovery is weaker than expected.

Some Fed officials are worried the bond program is already feeding into frothy housing and financial markets, and that continuing it could cause trouble down the road.

Kaplan noted that adjusting those purchases soon might give the Fed more flexibility over the discussion about interest rates.

"I've been more of a fan of doing some things maybe to take our foot gently off the accelerator sooner rather than later so that we can manage these risks" and make it more likely that the Fed will be able to "avoid having to press the brakes down the road," Kaplan said.

'HEALTHY DEBATE'

Under the new approach, officials are willing to overshoot the Fed's 2% inflation target for "some time" in order to achieve average 2% inflation and maximum employment.

Central bank policymakers will need to decide how much inflation they are comfortable with and for how long they would tolerate an overshoot of the Fed's target before adjusting monetary policy, Bullard said.

"What's the time frame for that and what's the magnitude of that?" he said. "I think that's a healthy debate to have."

Fresh economic projections released after the Fed's policy meeting last week showed 11 of 18 policymakers are penciling in at least two quarter-percentage-point rate increases by the end of 2023, a shift from March when a clear majority of policymakers favored no change to borrowing costs until 2024.

The tilt to a faster expected start to hiking rates caught markets by surprise. Kaplan said it was a reaction to a U.S. economic outlook that took a sharp turn between December and June.

As of December the path of the coronavirus pandemic remained uncertain, Kaplan said. "When we got to March it was clearer that we were going to get the pandemic under control," he said. And by June, the outlook received a "big upgrade" that made the core of officials expect rate increases in 2023 instead of 2024. "What you are seeing ... is monetary policymakers simply reacting to the dramatically improved economic outlook."

The discussion over how to adjust the Fed's asset purchases will include deciding whether to reduce purchases of mortgage-backed securities at a different pace than Treasury securities, when to start and how quickly to move, Bullard said.

"I don't think that this is an environment where you can just go on automatic pilot," Bullard said. "There's a lot of volatility in the macroeconomic data, so we are probably going to have be a little bit more ready than we were in 2014 to possibly make adjustments to our taper strategy."