The importance of predictability is underscored when one considers that in recent years, adverse economic shocks have generally been associated with sharp falls in longer-term interest rates. Such declines would tend to bring about faster MBS repayments and, if the outflow from the Federal Reserve’s portfolio were not constrained by a cap, an unforeseen tightening effect on financial conditions, amplifying the adverse shock. Prepared for the unexpected While I am confident that the FOMC’s plan will work well, there’s always the risk that events unfold differently than expected. In my view, we best prepare for the unexpected in two ways: we need to be operationally ready to change course when needed, and we need to remain analytically focused so we know when to recommend to policymakers that they do so. So long as the plan I’ve described to you proceeds uninterrupted and as expected toward normalization, it is likely that policymakers’ operational demands on the Desk will be considerably lighter than they have been over the last decade. However, it is possible that unexpected developments in the economy may require a change of plans. For example, the FOMC has made it clear in its addendum to the Policy Normalization Principles and Plans that it stands ready to resume reinvestment if a material deterioration in the economic outlook were to warrant a sizable reduction in the federal funds rate.
Taking this to the monetary policy context, expectations for disruption or volatility from an substantial change in the Federal Reserve’s operational posture, even if totally unfounded, could bring about disruption, as the holders of those expectations act to protect themselves or profit from what they believe is likely to come. The solution is to try to avoid generating such expectations for disruption to begin with, by acting gradually and predictably. 10 / 15  BIS central bankers' speeches  Another potential explanation for the relative stability of longer-term rates this time around is that balance sheet news this year, taken together, just hasn’t been all that surprising to market participants. Panel 6 shows market participants’ expectation for the level of the federal funds rate that would prevail when the reinvestment policy first changes, as well as expectations for the date of that change. As can be seen, balance sheet normalization started slightly earlier than expected, both in rate terms – it began with the federal funds rate at 1.16 percent – and, more notably, in terms of the absolute date. But at the same time, earlier in the year, many market participants had seen decent odds that the Federal Reserve would reduce its balance sheet more quickly with a full-stop end to reinvestment. Panel 7 shows the decline in expectations for both no change in Treasury reinvestments and a hard-stop in them.