Download U.S. Monetary Policy Since Late 2007 Structure of the Federal

3/4/2014
U.S. Monetary Policy Since
Late 2007
Winthrop P. Hambley
Senior Adviser
February 28, 2014
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Structure of the Federal
Reserve System
Board of Governors, Washington D.C.
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7 members nominated by the President, confirmed by the U.S. Senate
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Chair (now, Janet Yellen) and Vice Chair are separately nominated by the
President from among Board members, separately confirmed by the Senate.
12 Federal Reserve Banks, each with its own President
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each Reserve Bank has a nine member board of directors
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of these nine, the six board members chosen to represent the public nominate
the President of their bank (Dodd-Frank Act, 2010)
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Board of Governors approves or disapproves these nominations
Federal Open Market Committee
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Board members and Reserve Bank Presidents
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Federal Open Market Committee
(FOMC)
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key monetary-policy making body of FRS
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all 7 Board members, all 12 Bank Presidents participate in FOMC discussions of monetary
policy
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all Board members and 5 Bank Presidents (NY Fed President always, other Presidents in
rotation) vote at FOMC meetings
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Reserve Bank Presidents’ role in monetary policy promotes the Fed’s monetary policy
independence; their selection process is sometimes controversial
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FOMC meets at least 8 times a year in Washington, D.C.
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FOMC sets target level for federal funds rate — key monetary policy rate, traditional
monetary policy tool. In recent years, FOMC also undertook nontraditional monetary policy,
using three additional tools-- large scale asset purchases, enhanced communications with
the public about likely future policy (“forward guidance”), and changes in the maturity
composition of Federal Reserve’s asset holdings.
Governor Duke, “Come with Me to the FOMC,” 10/19/10, describes an FOMC meeting
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Monetary Policy Transparency
monetary policy transparency:
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decision on funds rate target and other policy actions announced immediately after FOMC
meetings, with brief explanation, in FOMC statement/press release. This includes votes by
name for or against the policy action; since 12/08 has included “forward guidance” on likely
future policy (see the latest FOMC release, below)
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minutes of each FOMC meeting released after three weeks (unique among central banks)
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edited transcripts of FOMC meetings, and all meeting materials, released after five years
(unique among central banks)
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Chair’s two (effectively, four) regular semiannual monetary policy testimonies, accompanied
by formal monetary policy reports, and numerous other Congressional testimonies by Chair
and Board members
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Since April, 2011, Chair has given quarterly monetary policy press briefings after FOMC
meetings (video available on Board’s web site); coincident release of Survey of Economic
Projections by FOMC participants
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weekly H.4.1 release shows effects of monetary policy on Fed’s assets, liabilities and
balance sheet (Fed is the only central bank that publishes its balance sheet)
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new explicit 2% PCE inflation goal, and disclosed range of estimated “longer-run normal rate
of unemployment” associated with “maximum employment” (range currently 5.2% to 6%)
clarify Fed’s understanding of its dual mandate and promote accountability. First stated in
FOMC principles, 1/25/12; reaffirmed 1/29/13 and 1/28/14.
The Federal Reserve is the most transparent central bank in the world.
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Monetary Policy Mandate
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The Federal Reserve is independent—operationally independent--but is not free to do
whatever it wants in monetary policy. Instead, “constrained discretion.”
Monetary policy reflects legal mandate established by Congress
Since 1977, goals of monetary policy have been established by law: monetary policy is to
promote “maximum employment, stable prices, and moderate long term interest rates.”
These terms, equal in statute, are not defined in the law.
Now, the “dual mandate”: Fed is to promote (1) maximum employment and (2) stable prices
(if both attained simultaneously, “moderate long term interest rates” would be achieved
automatically—real long-term interest rates consistent with full employment, no premium in
nominal interest rates for expected future inflation).
Most FOMC participants currently believe that the “mandate consistent” measure of
“maximum employment” is an unemployment rate in the range of 5.2% to 6%. They view an
inflation rate of 2% per year, measured by the PCE index, as consistent with their price
stability and maximum employment mandates.
At times, the two goals in the “dual mandate” may temporarily conflict, requiring tradeoffs.
In the long run, maximum sustainable employment is best achieved by attaining and
maintaining price stability. The two goals are ultimately complementary. (See Bernanke,
“The Benefits of Price Stability,” 2/06)
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Monetary Policy Mandate
New Chair Janet Yellen on the dual mandate:
“I strongly support both parts of the Federal Reserve’s dual mandate: price stability and
maximum employment. I have led the committee to produce a statement concerning its (the
FOMC’s—ed.) longer-run policy strategies and goals that puts both of these on an equal
footing.”
“I strongly support the Federal Reserve’s dual mandate, both parts of it. Both price stability and
employment matter enormously to American households. I think the dual mandate serves this
country well. And there is no conflict, most of the time and especially now, between pursing both
pieces of this.”
“I am committed to achieving both parts of our dual mandate—helping the economy return to full
employment and returning inflation to 2 percent, while ensuring that it does not run persistently
above or below that level.”
-- Yellen testimony at House Financial Services Committee, 2/11/14
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Achieving the Targeted Funds
Rate: Open Market Operations
Open market operations (OMO): Fed purchases, or sells, government securities in the market.
OMO are usually a means to an end--achieving a targeted level of the federal funds rate.
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banks and other depository institutions (DIs) have accounts at their bank, the Fed
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at any given time, some DIs have more balances in their accounts than they want or need
(for transactions, or to meet reserve requirements), and supply funds in the “federal funds”
market; others have fewer balances than they want or need, and demand funds in that
market
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the “federal funds rate” is the short term (overnight) interest rate DIs charge (or pay) one
another to lend (borrow) these balances; it equates the supply of, and demand for, balances
in the federal funds market
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normally, the Fed can control the federal funds rate quite closely—can keep it quite close to
the target for the funds rate established by the FOMC--through open market operations
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if the federal funds rate is above the FOMC’s target, the Fed buys government securities
from banks (or from primary dealers), and pays by adding to amounts in DIs’ (or primary
dealers’ banks’) accounts; this increases the supply of “federal funds” relative to the
demand, reducing the funds rate
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if the funds rate is below its target, the Fed sells government securities, taking payment from
buying DIs’ accounts, reducing the supply of federal funds, and raising the funds rate
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in normal times, if OMO are properly calibrated, the supply of federal funds will equal the
demand at the targeted level of the federal funds rate
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How Monetary Policy Works
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ordinarily, reductions in the federal funds rate provide financial stimulus, increase household and business
spending and increase “aggregate demand” in the economy. (Increases do the opposite.) How?
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monetary policy works, in part, via interest rates; Fed influences, but does not “set,” most interest rates
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the interest rate on a longer term loan to a given borrower is an average of the current short term rate and
currently expected future short term rates over the term of the loan, plus an additional amount (term
premium) compensating the lender for the risk of holding a longer-lived asset. (expectations /term premium
theory of term structure of interest rates)
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traditional monetary policy—the funds rate target, open market operations to achieve the target, and how
the Fed talks about its policy and the economy--affects both current short term rates and the expected path
of future short term rates, and thus affects two of the three determinants of longer term rates
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a lower funds rate tends to lower other short term interest rates. If also accompanied by a lower expected
path of future short term interest rates, this would also lower longer-term rates, stimulating spending by
consumers and businesses. (A higher funds rate accompanied by higher expected future short term rates,
in contrast, would raise long term rates, and restrain spending by consumers and businesses.)
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monetary policy is only one influence—although an important one-- on interest rates and on spending
decisions. Many things other than monetary policy (e.g., changing lender perceptions of credit risk and of
the risk of future inflation, stage of business cycle…) also affect interest rates, and many factors other than
interest rates affect spending (e.g. consumers’ wealth, current income, and confidence about the future;
the availability of credit to support consumer and business spending; government fiscal policies-- spending
and tax policies, economic conditions abroad...)
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How Monetary Policy Works
Monetary policy also affects spending indirectly by affecting asset prices and wealth, and exchange rates:
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Monetary policy affects asset prices, including stock prices and house prices, and thus affects household
wealth, an important determinant of consumer spending. For example, a reduction in interest rates will
reduce discount rates used to evaluate expected future dividends on stocks, and thus will generally be
associated with higher stock prices, greater wealth, and increased consumption spending. And if lower
long-term interest rates increase borrowing to buy houses, and thereby increase the demand for housing,
house prices will also be higher, also increasing wealth and consumption spending.
Stock prices are also an important influence on investment spending by businesses; higher stock prices will
tend to increase such spending.
Monetary policy also affects exchange rates which, in turn, affect U.S. and foreign demand for U.S.- made
goods and services. For example, if monetary policy results in lower U.S. interest rates (with foreign interest
rates unchanged), the U.S. will be a relatively less attractive place in which to invest. Foreigners wanting to
make fewer financial investments in the U.S. will decrease their demand for dollars, which will decrease the
price of the dollar in foreign exchange markets. A less expensive U.S. dollar will decrease the price of U.S.
goods to foreigners in their own currencies, which will tend to spur foreign demand for U.S. goods. Also, the
lower price of the dollar will make it relatively more expensive in dollars for Americans to buy foreign
goods, and Americans will switch some of their purchases from now more-expensive imports to now
relatively less-expensive U.S. goods and services. Both of these “switching effects“ increase the demand
for U.S. produced goods and services, and so tend to increase aggregate demand in the U.S.
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Monetary Policy Influences
Aggregate Demand
The key in monetary policy is to use the federal funds rate (or other policy tools) to try to
influence longer-term interest rates and, thus, overall spending decisions, and thereby align
“aggregate demand” with U.S. “potential output”—the output the economy could produce if
employment was at its maximum sustainable level (or, equivalently, if the unemployment rate
was at its lowest sustainable level). (Potential output is not known with certainty, but can be
estimated.)
“Potential output” changes over time, and usually grows, so this would involve not only trying to
align aggregate demand with (estimated) potential output, but also keeping aggregate demand
aligned with—and growing with-- this usually growing “moving target.”
The Fed wants to keep demand tracking potential output in a particular way over time: not
growing too slowly relative to potential output, which would cause excess supply, making
inflation slow or prices fall; and not growing faster than potential output, which would cause
demand to outstrip potential output, resulting in excess demand and inflation. It is seeking “price
stability”-- prices that are “stable,” not rising very much on average, over time.
If the Fed does these things, it will achieve both of the goals in its dual mandate.
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Responding to Shocks to
Aggregate Demand
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If a shock occurs that depresses aggregate demand below what is necessary to purchase potential output,
causing unemployment to rise—as happened in the recent Great Recession--monetary policy can respond
by acting to lower interest rates, in order to stimulate spending, and to arrest, limit, and ultimately offset the
decline in demand.
Monetary policy then can help demand to begin increasing, and then increasing faster than the growth of
potential output. In that way, monetary policy can help make demand and actual output “catch up” to
potential output, closing the “GDP gap” and lowering the unemployment rate to a rate consistent with
maximum employment.
This phase of demand expansion is essentially the situation the U.S. economy and monetary policy have
been in since the current recovery began in June 2009.
Stimulating the growth of demand in this way can also help to prevent an unwanted decline in the rate of
inflation below the targeted 2% rate thought consistent with price stability.
At some point, as the economy recovers, and demand and actual output approach potential output,
monetary policy will have to change and become less stimulative. The purpose of doing this would then be
to slow the growth of demand and actual output to the growth of potential output, so as to avoid
overshooting potential output and causing excess demand and inflation.
While “exiting” from accommodative policy, interest rates ultimately will have to rise to more “normal” levels,
in order to slow the growth of aggregate demand to the growth of potential output.
The “exit” phase of current monetary policy has not yet begun, and is sometime in the future.
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Difficulties in Monetary Policy
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monetary policy works with a lag, so
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policy cannot be solely based on “rear view mirror” data (which, in any case, are
often revised), but must also be informed by forecasts
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even if policy has intended effect on interest rates and spending—lowering
interest rates (and increasing asset prices) to increase the growth of aggregate
demand/spending in the current context-- other factors affecting spending may
comprise “headwinds” that work against that effect, tending to slow the growth of
aggregate demand. Monetary policy has had to contend with shifting
“headwinds” ever since the recovery began in mid-2009.
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the current headwinds may gradually be abating. (see section on current
“headwinds,” below)
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Recent Monetary Policy
End of the Housing Boom and the Situation in the Summer of 2007
By the summer of 2007, the housing boom had ended. After a long period of rising housing
demand, ever-faster house price increases, and expanding homebuilding, housing demand
had stopped growing. House prices had peaked sometime in 2006, ending expected future
house price appreciation. (chart, house price index)
At that point, homes had simply become too expensive for people to continue to buy, and to
borrow to pay for.
With the end of house price appreciation, investors’ speculative demand for housing abruptly
shrank.
In response, home sales and residential investment spending declined (and later fell much
further). Home-building and construction related employment contracted.
Thus, initially, residential construction and employment in homebuilding were a weak spot in the
real economy, otherwise strong and close to full employment.
With an excess supply of housing, and a large and growing inventory of unsold houses, house
prices started falling.
In the latter part of the housing boom, hybrid 2/28 and 3/27 mortgages had become common.
These loans had a fixed rate for the first two or three years. After those “introductory”
periods, their interest rates adjusted upward significantly, and, for the remaining 28 or 27
years varied with movements in an index. This design strongly “encouraged” borrowers to
refinance before rates reset in order to avoid the higher rates.
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Recent Monetary Policy
Because credit had been easily available, and home prices had been increasing, borrowers had
thought they could easily refinance existing loans, using the equity that they expected would
have built up in their home through rising house prices. Or, if necessary, they thought they could
sell their homes for more than they had borrowed to repay their mortgage debts. They expected
mortgage credit to continue to be readily available and expected to have built home equity
through price appreciation. (Lenders, expecting continued house price appreciation, agreed.)
But many of these borrowers had put little or nothing “down” when they borrowed. And when
house prices stopped rising, they were no longer building equity in their homes “automatically.”
Many other borrowers had taken out “option ARM” mortgage loans, which allowed them to pay
only interest--or even less than interest--each month. Having made only such small payments,
they had not paid down any principal on their mortgages—they had built little or no home equity
through their monthly mortgage payments. Still other homeowners had taken out and spent any
equity they had, by using “cash out” refinancing, or by drawing on home equity loans or home
equity lines of credit. As a result, many borrowers had little or no--or even negative--home
equity.
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Recent Monetary Policy (cont)
After a long period of good loan performance, helped by rising house prices and a strong
economy, lenders had begun to experience unexpectedly high losses on poorly
underwritten, now hard-to-refinance home loans, many of such poor quality that borrowers
defaulted very early in the term of the loans, and many others of which had suddenly
become more expensive to borrowers on a “monthly payment” basis, due to interest rate
resets or adjustments. (At first, this rise in delinquencies showed up in subprime ARMs, later
in other ARMs, later, with recession, in fixed rate loans). (chart, delinquency rates)
Rising mortgage delinquencies and defaults resulted in increased home foreclosures (chart) that
added to the excess supply of houses and thus, to downward pressure on house prices.
For the many borrowers with little or no equity in their homes, a drop in house prices meant
“negative equity”-- owing more on their homes than the homes were worth. This gave such
borrowers—even those who could make payments—an incentive not to repay their
mortgages, further increasing delinquencies and defaults. (This incentive later magnified by
a very large--one-third--cumulative decline in house prices.) The later recession, with higher
unemployment and lower incomes, further reduced borrowers’ ability to repay home loans.
Deteriorating mortgage performance and falling prices on homes securing home loans caused
unexpected losses for lenders, losses for investors on mortgage-backed securities (MBS)
and mortgage- related securities like CDOs, and losses for insurers of mortgages and
mortgage-related securities. The ultimate size and incidence of these losses across
institutions and investors was unclear, creating a fertile ground for the later financial panic.
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Recent Monetary Policy (cont)
With rising mortgage losses, demand for MBS and CDOs, and their prices, declined, causing
additional mark-to-market losses for financial institutions and investors that held them. In
response, lenders began to tighten the terms and availability of new mortgage credit, and
then of other forms of credit, from 2007 on, constraining aggregate demand.
All this was already underway in 2007, with the economy near full employment. Policy aimed to
prevent a further drop in aggregate demand, which would aggravate underlying problems. If
demand dropped, it would increase unemployment and lower incomes, reducing borrowers’
ability to repay all types of loans, further increasing mortgage (and other) loan losses, further
increasing foreclosures and excess housing supply, further reducing home prices and
depressing MBS and CDO values more, further damaging financial institutions, causing
them to tighten credit even more, further reducing aggregate demand…
By bolstering aggregate demand, policy aimed to forestall “negative feedback loops” between
the housing and mortgage markets, the financial system, and the macro-economy.
At first, in 2007, as investors shunned private label MBS, securitization of subprime mortgages
collapsed; later, in late 2008, “structured finance “ in general contracted sharply, making
credit for many types of spending –CRE, student loans, small business loans, etc.-- less
available and more expensive. Securitization suddenly became a far smaller source of credit
supporting spending, which had a significant negative impact on aggregate demand.
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Recent Monetary Policy (cont)
Monetary Policy Responds
From September of 2007 until mid-2009, the U.S. economy was weakening relative to its
potential. This happened slowly at first, then much more dramatically after mid-2008 and
into early 2009. (chart, GDP gap) A recession, now called “the Great Recession” because of
its length and depth, began in December of 2007 . (Shaded area in chart denotes
recession).
From late 2007 until the middle of 2008, the economy was growing (aggregate demand and
actual output were increasing), but more slowly than estimated potential output. A modest
“gap” opened up between actual output and estimated potential output, with actual output
below potential.
Coincident with the intensification of the financial crisis from 9/08 into early 2009 (“the Great
Panic”), aggregate demand and output began to fall in the third quarter of 2008, then fell
more rapidly in Q4 of 2008 and Q1of 2009. Sharply falling stock and house prices cut wealth
and aggregate demand. Three key components of U.S. aggregate demand--consumption,
investment, and net export spending--all fell. A concomitant recession and financial panic in
Europe and elsewhere intensified these effects.
The U.S. economy stopped declining in Q2 of 2009. By then, a big difference or gap had
developed between the “potential output” the economy could produce at full employment,
and the lower amount it was actually producing. With a delay, the unemployment rate
increased from 4.4% (its low) in May 2007, slowly at first, then faster after mid-2008, until
reaching a peak of 10% in October 2009. (chart, “unemployment rate”)
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Recent Monetary Policy (cont)
During this entire period, and continuing to the present, the Fed has aggressively sought to
boost the growth of aggregate demand through traditional monetary policy. (chart, “federal
funds rate target”)
In order to counter actual and expected macroeconomic weakness, starting in September of
2007 and continuing until December of 2008, the Fed rapidly reduced its target for the
federal funds rate from 5-1/4% to an historically exceptionally low range of 0% to ¼%
(nearly 100%). That “exceptionally low” range for the funds rate remains in place today.
Starting in December 2008, deeply worried about the overall economy, the Fed aggressively
used two nontraditional tools, including “large scale asset purchases” and “forward
guidance”—enhanced communications about the likely future path of the federal funds rate-to further lower longer-term interest rates in order provide more stimulus to demand.
Although aggregate demand did fall at first, and monetary policy, working with a lag, did not
avert a severe recession, aggressive policy easing prevented aggregate demand from being
lower, unemployment from being higher, and the housing and mortgage markets and the
financial system, from being in far worse condition at each later point in time.
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Recent Monetary Policy (cont)
Initially, the ultra-low federal funds rate, two early versions of enhanced communication aiming to
lower long term interest rates, and the initiation of a first round of large scale asset
purchases (see below) to lower term premiums and further lower long term rates—
combined with liquidity programs established by the Fed and other policies of the
federal government that prevented a collapse in the financial system, and also
combined with the incoming Obama Administration’s 2009 fiscal stimulus program-stopped an ongoing decline in aggregate demand by mid-2009. Consequently, a
much more serious recession—perhaps a second Great Depression and deflation
(prices falling on average peristently)--was avoided.
In mid-2009, in part because of aggressive monetary policy easing, aggregate demand and
output stopped falling, stabilized, then began rising, and then began to grow more
rapidly than potential output. The recession ended in mid- 2009, and the economy
began to recover. Demand growth accelerated in the second half of 2009, and the
economy registered 3.1% growth in real GDP in 2010. The Fed’s expansionary
monetary policy supported an earlier, stronger recovery than would have
otherwise occurred.
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Recent Monetary Policy (cont)
Later in the recovery, at times when demand growth faltered or was too slow to promote timely
attainment of the dual mandate, the Fed undertook:
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repeated efforts to strengthen communications about the likely future path of the federal
funds rate in order to further lower longer term interest rates (see below on “forward
guidance”);
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an explicit policy to maintain the size of the Fed’s balance sheet, whose purpose was to
avoid a passive tightening of policy that would otherwise have resulted from the runoff of
maturing assets;
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a second round of large scale asset purchases (see below);
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a “maturity extension” program that aimed at further lowering term premiums and longerterm interest rates (see below)
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and a third, open-ended, round of large scale purchases of mortgage backed securities and
Treasury securities that is still ongoing, albeit at a pace that was reduced in December
2013, and again in January 2014.
All of these “nontraditional” policies were undertaken in order to prod demand and output to keep
growing fast enough to outpace the growth of potential output, and thus to reduce the “GDP gap”
and lower the unemployment rate to a rate consistent with “maximum employment.” At times,
additional stimulus was also needed to forestall an unwanted decline in inflation.
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Recent Monetary Policy (end)
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Policy today is highly accommodative. The funds rate is essentially zero, cannot go lower,
and has been exceptionally low for more than five years.
Aggressive “forward guidance” currently suggests that the funds rate will not be increased
until the unemployment rate falls at least to 6 and 1/2%, and will remain exceptionally low
“likely well past the time that the unemployment rate declines below 6-1/2%, especially if
projected inflation continues to run below the Committee’s 2 percent longer-run goal.”
The Fed’s balance sheet has grown sharply, and is still growing rapidly. Two earlier rounds
of asset purchases greatly enlarged the Fed’s balance sheet; ongoing asset purchases are
currently adding $65 billion (earlier, $85 billion) in additional assets each month.
The Fed turned virtually all of its short term Treasury assets into longer term assets via
“maturity extension.”
All this easing is cumulative—one stimulative policy on top of another. Nonetheless, the
recovery has been slow and modest because policy has been, and still is, pushing against
strong “headwinds” which have tended to slow the growth of aggregate demand.
The unemployment rate, currently at 6.6% (Jan. 2013), remains well above the 5.2% to 6%
range of rates believed consistent with “maximum employment.” It is expected to gradually
decline. Annual PCE inflation, currently 1% (Dec. 2013) is well below the FOMC’s 2%
target. It is expected to gradually rise, but still to remain below 2% for the next several years.
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Monetary Policy Balances
Benefits and Costs
Potential Benefits of Policy Easing through low funds rate, LSAPs, MEP, Forward Guidance:
Downward pressure on longer-term interest rates:
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fosters stronger recovery, increasing employment and output and promotes attainment of
“maximum employment”
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maintains inflation closer to the FOMC’s 2% target
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guards against downside risks to the economy
But potential benefits must be weighed continually against potential costs.
Potential Costs of Policy Easing through Lower Longer-Term Rates:
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could increase expectations of future inflation and actual future inflation
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could impair market functioning in Treasury or MBS markets
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enlarged balance sheet could potentially complicate exit strategy
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could adversely affect financial stability, by inducing investors and financial institutions to
“reach for yield” imprudently--that is, increase their risk-taking in order to raise expected
returns on investments.
Balance between potential benefits and costs may change over time.
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Large Scale Asset Purchases
Starting in late 2008, the Federal Reserve has engaged in three rounds of “large scale asset
purchases” (“LSAPs”):
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From December 2008 until March of 2010, the Fed bought $1.7 trillion worth of three types
of assets: mortgage backed securities (MBS) guaranteed by Fannie Mae and Freddie Mac,
debt issued by these entities, and Treasury securities. (First round of LSAPs was called
“quantitative easing” by the press—”QE” for short.)
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On November 3, 2010, the Fed announced a second round of large scale asset purchases,
this time $600 billion worth of longer-term Treasury securities, that continued through June,
2011 (“QE 2” )
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Through the first two rounds of LSAPs, in 2½ years, the Fed added $2.3 trillion to its asset
holdings, and tripled in asset size.
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Starting in September, 2012, the Fed began to buy $40 billion per month in MBS guaranteed
by Fannie Mae and Freddie Mac. Unlike earlier LSAPs/ QE, the total amount to be bought
was open-ended, that is, no total amount of purchases was preannounced. In December of
2012, the Fed also began to buy longer-term Treasury securities, initially at a rate of $45
billion per month. Again, the amount to be bought was open-ended. (“QE 3”). These
amounts were each reduced by $5 billion per month starting in January of 2014, and each
by a further $5 billion per month In February 2014. But the Fed is still adding assets rapidly.
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How LSAPs Work and How
Much
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Large scale asset purchases work through a “portfolio balance channel” to lower term
premiums and longer-term interest rates. Bernanke 8/31/12: “different classes of assets are
not perfect substitutes in investors’ portfolios… Imperfect substitutability of assets implies
that changes in the supplies of various assets available to private investors may affect the
prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed
securities (MBS), for example, should raise the prices and lower the yields of those
securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the
Federal Reserve with other assets, the prices of the assets they buy should rise and their
yields should decline as well. Declining yields and rising asset prices ease overall financial
conditions and stimulate economic activity through channels similar to those for
conventional monetary policy.” (Bernanke, 11/20/12: same results if buying Treasuries.)
Research shows Fed’s purchases of MBS, GSE debt, and Treasury debt have had the
intended effect of (reducing term premiums, thereby) lowering longer term interest rates,
including mortgage interest rates. Such effects have buoyed aggregate demand.
Bernanke, 8/31/12: “studies have found that the $1.7 trillion in purchases of Treasury and
agency securities under the first LSAP program reduced the yield on 10-year Treasury
securities by between 40 and 110 basis points. …the first (LSAP) program, in particular, has
been linked to substantial reductions in MBS yields and retail mortgage rates. “
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How LSAPs Work and How
Much(cont.)
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Bernanke 8/31/12: “The $600 billion in Treasury purchases under the second LSAP program
has been credited with lowering 10-year yields by an additional 15 to 45 basis points.”
Bernanke, 8/31/12, “Three studies considering the cumulative influence of all the Federal
Reserve’s asset purchases (including the MEP) found total effects between 80 and 120
basis points on the 10-year Treasury yield.”
LSAP effects on stock prices and wealth likely also helped to buoy demand. Bernanke,
8/31/12: “LSAPs also appear to have boosted stock prices, presumably both by lowering
discount rates and by improving the economic outlook; it is probably not a coincidence that
the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s
decision to greatly expand securities purchases. The effect is potentially important because
stock values affect both consumption and investment decisions.”
Bernanke, 8/31/12: “model simulations conducted at the Board find that securities purchase
programs have provided significant help for the economy.” A simulation using the FRB/US
model of the U.S economy found that “as of 2012, the first two rounds of LSAPs may have
raised the level of output by almost 3 percent and increased private payroll employment by
more than 2 million jobs, relative to what otherwise would have occurred.”
Bernanke, 8/31/12: “evidence shows that “securities purchases have provided meaningful
support to the economic recovery while mitigating deflationary risks.”
25
How LSAPs Work and How
Much (end)

In summary: “For the most part, research supports the conclusion that the combination of
forward guidance and large-scale asset purchases has helped promote the recovery. For
example, changes in guidance appear to shift interest rate expectations, and the
preponderance of studies show that asset purchases push down longer-term interest rates
and boost asset prices. These changes in financial conditions in turn appear to have
provided material support to the economy.” (then-Chairman Bernanke 1/3/14)

New Chair Janet Yellen: “I think that quantitative easing, or purchases of securities, did
serve to push down mortgage rates, and other longer-term interest rates quite
substantially…” (testimony at House Financial Services Committee, 2/11/14)
26
13
3/4/2014
Potential Costs of Large Scale
Asset Purchases
Then-Chairman Bernanke has previously noted that LSAPs (and accommodative policies
generally) have potential costs, while noting that those costs have not yet materialized:

potential disruption of securities markets by LSAPs—but “to this point we have seen few if
any problems in the markets for Treasury or agency securities.” (8/31/12)

further expansion of the Fed’s balance sheet could reduce public confidence in the Fed’s
ability to exit smoothly from its accommodative policies at the appropriate time—but “the
expansion of the balance sheet to date has not materially influenced inflation expectations,
likely in part because of the great emphasis the Federal Reserve has placed on developing
tools to ensure that we can normalize monetary policy when appropriate.” (8/31/12)

LSAPs, and prolonged low longer-term interest rates, potentially create risks to financial
stability. By driving long term yields lower, policy could induce an imprudent “reach for yield”
by some investors who take on more credit risk, duration risk, or leverage, thereby
threatening financial stability—but ”little evidence thus far of unsafe buildups of risk or
leverage.”(8/31/12) Bottom line: “To this point we do not see the potential costs of the
increased risk-taking… as outweighing the benefits.” (2/26/13). At the same time, “the
Federal Reserve is working to address financial stability concerns through increased
monitoring, a more systemic approach to supervising financial firms, and reform to make the
financial system more resilient.” (5/22/13)
27
Potential Costs of Large Scale
Asset Purchases (end)

The Federal Reserve could incur financial losses due to a rise in interest rates--but
“Extensive analyses suggest that…the odds are strong that the Fed’s asset purchases will
make money for the taxpayers, reducing the federal deficit and debt. And, of course, to the
extent that monetary policy helps strengthen the economy and raise incomes, the benefits
for the U.S. fiscal position would be substantial.” (8/31/12)
Like former Chairman Bernanke, new Fed Chair Yellen views the potential of current monetary
policy to create future financial instability as the most serious potential risk. As she stated in
testimony at the House Financial Services Committee on February 11, 2014:
“We recognize that in an environment of low interest rates like we’ve had in the United States
now for quite some time, there may be an incentive to reach for yield, and that we do have the
potential to develop asset bubbles or a buildup of leverage or rapid credit growth or other threats
to financial stability. So especially given that our monetary policy is so accommodative, we’re
highly focused on trying to identify those threats. … Broadly speaking, we haven’t seen leverage,
credit growth, (or) asset prices build to the point where generally I would say that they were at
worrisome levels. …looking at a range of traditional valuation measures doesn’t suggest that
asset prices, broadly speaking, are in bubble territory or outside of normal historical ranges.”
28
14
3/4/2014
Maturity Extension Program




Beginning in August, 2011, and ending in June 2012, the Federal Reserve sold $400 billion
of shorter-term Treasury securities and bought an equivalent amount of longer-term
Treasury securities. This increased the average remaining term to maturity of the Federal
Reserve’s Treasury securities holdings. This was the Fed’s “maturity extension program,”
(MEP).
In June 2012, the FOMC extended the MEP until the end of 2012, selling an additional $267
billion in shorter-term Treasury securities and buying more longer-term Treasury securities.
By reducing the average maturity of securities held by the public, the MEP “puts additional
downward pressure on longer-term interest rates and further eases overall financial
conditions.”(Bernanke 9/4/12). More formally, the MEP took “duration” and interest rate risk
out of the market, making the public willing to hold remaining longer term Treasuries at a
higher price and lower yield; spillover effects lowered other interest rates. MEP was done in
order to further lower longer term interest rate and further increase aggregate demand.
MEP did not change the size of the Federal Reserve’s balance sheet. While the composition
of its assets shifted toward longer maturities, total assets remained the same. Since, on net,
no new assets were bought, no net additional balances were credited to depository
institutions either, so the Fed’s total liabilities also remained unchanged. MEP was additional
stimulus without making the Federal Reserve’s balance sheet bigger.
29
Forward Guidance
Currently, there are two categories of “forward guidance”—(1) guidance on the likely future path
of the federal funds rate and (2) guidance on the likely future course of asset purchases:
1. Forward Guidance on the Federal Funds Rate:
Since late 2008, the FOMC has used “forward guidance” about the likely future of the range for
the federal funds rate to encourage the public to believe that the Fed would keep the federal
funds rate very low for longer than previously expected. In its press releases, the FOMC stated,
successively, that it expected the federal funds rate would remain “exceptionally low”:

“for some time” (starting in the December 2008 FOMC release)

“for an extended period” (starting in March 2009)

“at least until mid-2013” (starting in August 2011)

“at least until late 2014” (starting in January 2012)

“at least until mid-2015” (starting in September 2012, continued until December 2012).
Such communications lowered the expected future path of the funds rate and of other short term
rates, and so tended to lower longer term rates (which, recall, are averages of current short term
rates and expected future short term rates, plus an additional amount or “term premium”).
30
15
3/4/2014
Forward Guidance (cont.)
12/12 Changes to Forward Guidance on the Funds Rate: “State Contingent Guidance”
In December, 2012, the FOMC abandoned date-based communications (such as “at least until
mid-2015”) about the anticipated future path of the range of the federal funds rate.
In a major change, the FOMC then tied the funds rate range to quantitative economic conditions,
stating that the Committee then anticipated that its exceptionally low target range for the federal
funds rate of 0- ¼ percent “will be appropriate at least as long as the unemployment rate
remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no
more than a half percentage point above the Committee’s 2 percent longer-run goal, and longerterm inflation expectations continue to be well-anchored.” (emphasis added). This guidance has
remained in all subsequent FOMC releases.
This quantitative guidance provided information about the objective circumstances under which
policy—as reflected in the federal funds rate-- could begin to be tightened. But, as Chairman
Bernanke then stressed, this statement did not put monetary policy on autopilot. For example, it
did not mean that the funds rate target would automatically be increased when the
unemployment rate reached 6.5%, only that the FOMC wouldn’t consider raising it before then.
31
Forward Guidance (cont.)
This guidance on Fed’s range for funds rate was intended to be more transparent; previously,
the market was not sure of why Fed chose, or changed, the calendar dates in its guidance.
Since September 2012, and still today, the FOMC has also stated that it “expects that a highly
accommodative stance of monetary policy will remain appropriate for a considerable time after
the asset purchase program ends and the economic recovery strengthens. “ (italics added)
As Chairman Bernanke later (2/26/13) said that the guidance also “serve(d) to underscore the
Committee’s intention to maintain accommodation as long as needed to promote a stronger
economic recovery with stable prices.”
32
16
3/4/2014
Forward Guidance (cont.)
December 2013 change to forward guidance on the most likely future path of the funds rate:
In December 2013, because of substantial cumulative improvement in labor market conditions
and in the labor market outlook, the FOMC decided to begin slowing down the monthly pace of
its third round of asset purchases, in anticipation of gradually ending purchases. It coupled this
decision with stronger forward guidance on the funds rate.
After repeating that the FOMC continued to expect that the “exceptionally low’ range of the
federal funds rate would remain appropriate at least as long as the unemployment rate exceeded
6 -1/2 percent…” (italics added), the Committee added the following strengthening statement:
“The Committee now anticipates …that it will likely be appropriate to maintain the current target
range for the federal funds rate well past the time that unemployment rate declines below 6-1/2
percent, especially if projected inflation continues to run below the Committee’s 2 percent longerrun goal.” (italics added)
The wording in the last two paragraphs remains the current guidance on the funds rate.
33
Forward Guidance (cont.)
2. Forward Guidance on Asset Purchases
In September 2012, the FOMC announced a new, third, open-ended round of large scale asset
purchases, specifically, purchases of mortgage backed securities, MBS. Initially, $40 billion of
such securities would be purchased each month.
This announcement was accompanied by a statement setting out qualitative criteria concerning
how long the FOMC would continue these MBS purchases. These criteria said that asset
purchases would continue until there was a substantial improvement in the outlook for the labor
market (emphasis added) “achieved in a context of price stability”.
The initial version of this guidance in the September 2012 FOMC release, stated; “If the outlook
for the labor market does not improve substantially, the Committee will continue its purchases of
agency mortgage backed securities, undertake additional asset purchases, and employ its other
policy tools as appropriate until such improvement is achieved in a context of price stability.”
34
17
3/4/2014
Forward Guidance (cont.)
In December 2012, the FOMC announced it would begin purchasing longer-term Treasury
securities, initially at a rate of $45 billion per month. (These purchases replaced the purchases of
longer term Treasuries under the MEP, which was ending, and would be in addition to the
ongoing MBS purchases.)
The FOMC then repeated its earlier qualitative guidance for asset purchases (after broadening it
to include purchases of both Treasury securities and MBS), again stating that “If the outlook for
the labor market does not improve substantially, the Committee will continue its purchases of
Treasury and agency mortgage backed securities, and employ its other policy tools as
appropriate, until such improvement is achieved in a context of price stability.”
This guidance on asset purchases later evolved into the following form, which still tied the end of
the Fed’s asset purchases to achieving a substantial improvement in the outlook for the labor
market, and also to price stability. As the FOMC stated in September, 2013, “The
Committee….will continue its purchases of Treasury and agency mortgage backed securities,
and employ its other policy tools as appropriate, until the outlook for the labor market has
improved substantially in a context of price stability.” (emphasis added) This statement remains
in the most recent FOMC releases.
35
Forward Guidance (cont.)
The FOMC explained how it will decide when to start tapering its asset purchases in the release
following its September and October 2013 meetings:
“In judging when to moderate the pace of asset purchases, the Committee will, at its coming
meetings, assess whether incoming information continues to support the Committee’s
expectation of ongoing improvement in labor market conditions and inflation moving back toward
its longer-run objective. Asset purchases are not on a preset course, and the Committee’s
decisions about their pace will remain contingent on the Committee’s economic outlook as well
as its assessment of the likely efficacy and costs of such purchases.”
At its December 2013 meeting, the FOMC began to reduce the pace of its asset purchases from
$85 billion per month to $75 billion per month. That reflected a judgment that by then there had
finally been both substantial cumulative progress in actual labor market conditions and a
substantial improvement in the outlook for the labor market.
36
18
3/4/2014
Forward Guidance (cont.)
In December 2013, when announcing its decision to reduce the monthly rate of its asset
purchases by $10 billion, the FOMC added the following statement about the likely future course
of asset purchases:
“If incoming information broadly supports the Committee’s expectation of ongoing improvement
in labor market conditions and inflation moving back toward its longer–run objective, the
Committee will likely reduce the pace of asset purchases in further measured steps at future
meetings. However, asset purchases are not on a preset course, and the Committee’s decisions
about their pace will remain contingent on the Committee’s outlook for the labor market and
inflation, as well as its assessment of the likely efficacy and costs of such purchases.”
In January 2014, the FOMC reduced the monthly pace of its asset purchases by a further $10
billion, and repeated the statement in the preceding paragraph. Thus, going forward, if
developments continue to show ongoing improvement in labor market conditions and in the labor
market outlook and inflation rising toward 2%, the FOMC will likely continue to taper purchases
at future meetings.
37
Forward Guidance (cont.)
In sum, now that the Fed has begun to taper its asset purchases, under current guidance about
the funds rate target and asset purchases, the sequence of future monetary policy changes will
likely be:




first, if conditions suggest an ongoing improvement in labor market conditions and in the
future outlook for the labor market, and inflation moving back to the FOMC’s 2% target, “the
Committee will likely reduce the pace of asset purchases in further measured steps at future
meetings.”
second, ultimately, the FOMC will end new asset purchases; the stock of Fed assets will
peak
third, it will then allow a “considerable time” to pass after the asset purchase program ends
and the economic recovery strengthens. During this time, consistent with current policy, the
Fed would maintain the size of its balance sheet by reinvesting proceeds of any securities
that mature in new securities. This would maintain downward pressure on interest rates.
fourth, when the unemployment rate falls to 6.5%--closer to its sustainable “long run normal”
level—and provided the projected inflation rate then was no higher than 2.5%--the FOMC
could consider starting to remove monetary policy accommodation by increasing the
targeted range for the funds rate.
38
19
3/4/2014
Forward Guidance (end)


however, fifth, the FOMC currently expects “that it likely will be appropriate to maintain the
current target range for the federal funds rate well past the time that the unemployment rate
declines below 6-1/2 percent, especially if projected inflation continues to run below the
Committee’s 2 percent objective. (italics added)
finally, “When the Committee decides to begin to remove policy accommodation, it will take
a balanced approach consistent with it longer-run goals of maximum employment and
inflation of 2 percent.”
39
The Timing of “Tapering”
At his press conference on June 19, 2013 , Chairman Bernanke said the Federal Reserve might
start to reduce its then-current round of large scale asset purchases “later this year,” and end
them “around the middle of 2014,” provided the economy followed the path of moderate recovery
then forecast by the Fed. He stated:
“If the incoming data are broadly consistent with this forecast, the (Federal Open Market)
Committee currently anticipates that it would be appropriate to moderate the pace of purchases
later this year. If the subsequent data remain broadly aligned with outrcurrent expectations for
the economy, we will continue to reduce the pace of purchases in measured steps through the
first half of next year, ending purchases around mid-year.” Thus, LSAPs would end mid-2014.
This possible timeline for tapering, and then ending, asset purchases, was dependent on the
Fed’s forecasts, and on the evolution of the economy over time being ”broadly aligned” with the
Fed’s expectations.
The actual timeline for tapering, then ending, asset purchases was always (and still is) data
dependent—it depended on the state of the economy in the future, as reflected in data then
available, and how it compared to forecasted outcomes.
40
20
3/4/2014
The Timing of “Tapering”



At its September and October 2013 meetings, the FOMC delayed the start of tapering based
on the judgment that the test of “substantial improvement in the outlook for the labor market”
had not yet been met.
In December 2013, incoming data finally seemed to suggest both substantial cumulative
improvement in labor market conditions and that there was a “substantial improvement in
the outlook for the labor market,” and the FOMC decided to begin to taper its asset
purchases starting in January 2014.
In January 2014, the FOMC decided to taper further, starting in February.
41
Credit Easing and the Fed’s
Balance Sheet
Since mid-July of 2007 (just before the onset of the financial crisis) the size of the Federal
Reserve’s balance sheet has increased dramatically. (H.4.1 releases, 7/19/07, 2/20/14):

The Federal Reserve’s assets have more than quadrupled from $876 billion to $4.15 trillion

composition and average maturity of Fed assets has changed dramatically since mid-2007:





U.S. government securities holdings increased from $790 billion to $2.27 trillion;
holdings of Fannie Mae- and Freddie Mac-guaranteed MBS—which Fed didn’t previously hold-- have risen sharply, and
now total $1.57 trillion. (Fed also holds $51 billion in debt issued by Fannie and Freddie, an asset not previously held.).
in addition, via maturity extension, average maturity of Federal Reserve’s Treasury securities holdings has increased
FR liabilities have also increased sharply. Deposits of depository institutions at Reserve
Banks (which are liabilities of the Federal Reserve) have increased from $20 billion to $2.61
trillion. Nearly all of this is excess reserves. (Currency outstanding—the Fed’s other main
liability--is now $1.2 trillion.)
The huge amount of excess reserves, if lent, could support inappropriately low future
interest rates, and a substantial future increase in bank lending and aggregate demand.
Currently, overall bank lending is increasing slowly, so this is only a potential future risk.
Ultimately, though, as aggregate demand and credit demand strengthen and the economy
recovers, these excess reserves will need to be drained or neutralized, the balance sheet
shrunk, communications changed, and interest rates nudged higher, or “normalized,” to
avoid excessive stimulus to future aggregate demand that could cause future inflation.
42
21
3/4/2014
Will Monetary Policy
Increase Future Inflation?
Chairman Bernanke: 10/1/12:
“The Fed’s price stability record is excellent, and we are fully committed to maintaining it.
Inflation has averaged close to 2 percent per year for several decades, and that’s about where it
is today. In particular, the low interest rate policies the Fed has been following for about five
years now have not led to increased inflation.
“For controlling inflation, the key question is whether the Federal Reserve has the policy tools to
tighten monetary conditions at the right time so as to prevent the emergence of inflationary
pressures down the road. I’m confident that we have the necessary tools to withdraw policy
accommodation when needed…
“Of course, having effective tools is one thing; using them in a timely way, neither too early nor
too late, is another. Determining precisely the right time to “take away the punch bowl” is always
a challenge for central bankers, but that is true whether they are using traditional or
nontraditional policy tools.”
43
FOMC Release 1/29/14
“Information received since the Federal Open Market Committee met in December indicates
that growth in economic activity picked up in recent quarters. Labor market indicators were
mixed but on balance showed further improvement. The unemployment rate declined but
remains elevated. Household spending and business fixed investment advanced more
quickly in recent months, while the recovery in the housing sector slowed somewhat. Fiscal
policy is restraining economic growth, although the extent of restraint is diminishing. Inflation
has been running below the Committee’s longer-run objective, but longer-term inflation
expectations have remained stable.
“Consistent with its statutory mandate, the Committee seeks to foster maximum employment
and price stability. The Committee expects that, with appropriate policy accommodation,
economic growth will expand at a moderate pace and the unemployment rate will gradually
decline toward levels the Committee judges consistent with its dual mandate. The
Committee sees the risks to the outlook for the economy and the labor market as having
become more nearly balanced. The Committee recognizes that inflation persistently below
its 2 percent objective could pose risks to economic performance, and is monitoring inflation
developments carefully for evidence that inflation will move back toward its objective over
the medium term.
44
22
3/4/2014
FOMC Release 1/29/14
(cont.)
“Taking into account the extent of federal fiscal retrenchment since the inception of its current
asset purchase program, the Committee continues to see the improvement in economic activity
and labor market conditions over that period as consistent with growing underlying strength in
the broader economy. In light of the cumulative progress toward maximum employment and the
improvement in the outlook for labor market conditions, the Committee decided to make a further
measured reduction in its pace of asset purchases. Beginning in February, the Committee will
add to its holdings of agency mortgage-backed securities at pace of $30 billion per month rather
than $35 billion per month, and will add to its holdings of longer-term Treasury securities at a
pace of $35 billion per month rather than $40 billion per month. The Committee is maintaining its
existing policy of reinvesting principal payments from its holdings of agency debt and agency
mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing
Treasury securities at auction. The Committee’s sizeable and still-increasing holdings of longerterm securities should maintain downward pressure on longer-term interest rates, support
mortgage markets, and help to make broader financial conditions more accommodative, which in
turn should promote a stronger economic recovery and help to ensure that inflation, over time, is
at the rate most consistent with the Committee’s dual mandate.
45
FOMC Release 1/29/14
(cont.)
“The Committee will closely monitor incoming information on economic and financial
developments in coming months, and will continue its purchases of Treasury and agency
mortgage-backed securities, and employ its other policy tools as appropriate, until the
outlook for the labor market has improved substantially in a context of price stability. If
incoming information broadly supports the Committee’s expectation of ongoing improvement
in labor market conditions and inflation moving back toward its longer-run objective, the
Committee will likely reduce the pace of asset purchases in further measured steps at future
meetings. However, asset purchases are not on a preset course, and the Committee’s
decisions about their pace will remain contingent on the Committee’s outlook for the labor
market and inflation as well as its assessment of the likely efficacy and costs of such
purchases.
46
23
3/4/2014
FOMC release, 1/29/14 (end)
“To support continued progress toward maximum employment and price stability, the Committee
today reaffirmed its view that a highly accommodative stance of monetary policy will remain
appropriate for a considerable time after the asset purchase program ends and the economic
recovery strengthens. The Committee also reaffirmed its expectation that the currently
exceptionally low target range for the federal funds rate of 0 to ¼ percent will be appropriate at
least a long as the unemployment rate remains above 6-1/2 percent, inflation between one and
two years ahead is projected to be no more than a half percentage point above the Committee’s
2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In
determining how long to maintain a highly accommodative stance of monetary policy, the
Committee will also consider other information, including additional measures of labor market
conditions, indicators of inflation pressures and inflation expectations, and readings on financial
developments. The Committee continues to anticipate, based on its assessment of these factors,
that it likely will be appropriate to maintain the current target range for the federal funds rate well
past the time that the unemployment rate declines below 6-1/2 percent, especially if projected
inflation continues to run below the Committee’s 2 percent longer-run goal. When the Committee
decides to begin to remove policy accommodation, it will take a balanced approach consistent
with its longer-run goals of maximum employment and inflation of 2 percent.”
Statement adopted by a vote of 10-0.
47
“Headwinds” that slowed
demand growth are abating





Until recently, fiscal contraction—federal tax increases and ongoing spending cuts—has
tended to slow the growth of aggregate demand; future federal fiscal policy has also been
highly uncertain, which has inhibited investment spending. But fiscal headwinds are abating,
and are expected to ebb further in next several years.
past tight credit conditions for some borrowers (borrowers with less-than-perfect credit
qualifications seeking home mortgage credit; borrowers seeking small business loans…)
may be abating as well. (Ex: modestly lower average mortgage FICO scores last year)
the euro zone, previously in recession is only now slowly emerging from recession. These
have restrained the demand for U.S. exports and the growth of U.S. aggregate demand. But
euro zone and world growth seems to be picking up, so this headwind also abating.
deleveraging by households has restrained consumer borrowing and spending, but, with
substantial deleveraging now achieved, effects may be abating. (Ex. Recent strong growth
in auto production, sales and auto loans, and in student enrollments and student loans.)
Thus far during this recovery, residential investment has contributed far less to recovery
than it typically does. Post-May 2013 rise in long-term interest rates and “tightening of
financial conditions”—partly reversed since—has slowed housing recovery. But residential
investment has improved from a low base, and further improvement is likely.
48
24
3/4/2014
Exit Strategy: Timing





Even with tapering of asset purchases, current monetary policy is highly expansionary,
appropriately so, with aggregate demand insufficient and growing relatively slowly,
unemployment relatively high and inflation in check and below target.
Still, as demand increases and the recovery takes hold, the Fed will ultimately need to
reverse course, undo its non-traditional policies, remove policy accommodation, and
“normalize” policy, allowing interest rates to rise to more normal levels. That is, it will have to
stop buying assets, change its communications, shrink its balance sheet and/or drain or
immobilize excess reserves, and raise the federal funds rate (and bump other interest rates)
to more normal levels, in order to prevent excessive stimulus to demand that would cause
future inflation.
Given the lags in the effect of monetary policy, a successful exit will depend on good
timing—not withdrawing stimulus too soon (risking another recession), and not withdrawing
stimulus too late (risking excess demand and inflation).
The timing problem is one usually faced by the Fed when tightening policy during a
recovery, but in this case it is complicated by the need to phase out nontraditional policy.
Timing of exit-related policy will be based on forecasts and judgments about the need for
continued stimulus.
49
Exit Strategy: Tools
At some point, it will be necessary to “normalize” monetary policy and raise interest rates.
The Fed has the tools necessary to do this:

To raise the federal funds rate and other short term rates, even with an enlarged balance
sheet and substantial excess reserves in the system, the Fed can increase the rate of
interest paid on excess reserves. The payment of interest on excess reserves in accounts at
the Fed tends to put a floor under the federal funds rate, because no DI will lend at a lower
rate in the funds market if it can make a risk-free loan to the Fed and earn interest at the
interest rate the Fed pays on excess reserves. Therefore, a higher rate paid on excess
reserve would tend to raise the floor, and the federal funds rate with it.

To shrink its balance sheet (and in so doing, shrink excess reserves), Fed can allow existing
securities to mature and run off without replacing them. It can also actively sell securities, or
engage in “reverse repurchase” transactions. One type of “reverse repo”--the overnight,
fixed rate, full allotment version—would also strengthen control over the funds rate.

Alternatively, Fed could eliminate excess reserves by encouraging DIs to convert them into
longer-term, interest-earning savings deposits (‘term deposits”) at the Reserve Banks—
deposits that wouldn’t qualify to meet reserve requirements.
50
25
3/4/2014
Exit Strategy: Sequencing





Exit strategy also requires proper sequencing of use of available tools. In what order will
available tools be used to reverse course and to push up longer-term interest rates?
First, with an ongoing “substantial improvement in the outlook for the labor market in a
context of price stability” new monthly asset purchases will continue fo gradually diminish;
purchases will taper, and ultimately end. At that point, Fed will stop adding accommodation.
Maintaining the size of its then-existing asset holdings will maintain accommodation.
After the passage of time, when the unemployment rate has fallen at least to 6-1/2%, and
provided projected medium-term inflation is under control, the Fed will consider beginning to
withdraw accommodation. But the FOMC currently thinks the current target for the funds
rate “likely will be appropriate….well past the time the unemployment rate declines below 61/2 percent, especially if projected inflation continues to run below the Committee’s 2
percent objective.”
initial policy tightening, when it comes, should result from allowing existing securities
holdings to mature and not reinvesting the proceeds. This will gradually shrink the Fed’s
balance sheet and drain excess reserves from the banking system, as balances are
withdrawn from accounts at Fed.
Then, or thereafter, the FOMC will initiate temporary reserve draining operations (via
reverse repos or auctioning of term deposits)
51
Exit Strategy: Sequencing


Subsequently, the Fed will begin to raise the target for the funds rate, and increase the
actual federal funds rate by raising the interest rate paid on excess reserves
Finally, actively selling Treasury securities to further reduce reserves in the banking system.
Sales of Treasury securities would occur over 3-5 years. (MBS would not be sold.)
52
26
3/4/2014
Exit Strategy: Will






To avoid future inflation, the Fed will need eventually to act to prod longer-term interest rates
to higher, more normal levels through deliberate policy actions.
Higher interest rates are always unpopular.
Because of lags in the effect of policy, monetary policy will have to be tightened before
recovery is fully achieved--with unemployment still above its longer-term sustainable level-making tightening even more unpopular. Tightening may seem premature, and may be
criticized.
In pushing up longer-term interest rates, Fed will also be removing support for specific
interest-sensitive parts of the economy, notably housing construction and the mortgage
market.
Opposition to tightening could be politically potent. Congress could resist necessary
tightening.
Does the Federal Reserve have the will to do what needs to be done, when it needs to be
done? When the time comes, the Fed will act to meet its dual mandate.
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For more information…
Board’s public website www.federalreserve.gov
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FOMC releases and minutes, monetary policy testimonies and speeches, H.4.1 release
(Fed’s balance sheet), etc.
Recent monetary policy speeches, testimonies, statements and FOMC minutes:
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Chair Janet Yellen, semiannual monetary policy testimony, February 11, 2014
Vice Chair Yellen, statement at hearing on her nomination to be Fed Chair, 11/14/13
Minutes of the January 28-29, 2014 FOMC meeting
Yellen, “Communication in Monetary Policy,” 4/4/13
then-Chairman Bernanke, “Monetary Policy and the Global Economy,” 3/25/13
Yellen, “Challenges Confronting Monetary Policy,” 3/4/13
FOMC principles on monetary policy goals and strategy, 1/29/14
Questions? My e-mail address is: [email protected]
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