Download An Introduction to the Federal Reserve System

U.S. Monetary Policy Since
Late 2007
Winthrop P. Hambley
Senior Adviser
April 15, 2014
1
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 (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 chosen to represent the public nominate the President of
their bank (Dodd-Frank Act, 2010)
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the Board of Governors approves or disapproves these nominations
Federal Open Market Committee
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Board members and Reserve Bank Presidents
2
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
FOMC meets at least 8 times a year in Washington, D.C.
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
3
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 goals, equal in statute, are not defined in the law.
These goals now called 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 former
Chairman Bernanke, “The Benefits of Price Stability,” 2/06)
4
Monetary Policy Mandate
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 Committee on Financial Services, 2/11/14
5
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 re: funds rate and/or asset purchases (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 (SEP)
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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.
6
Open Market Operations:
Achieving the Funds Rate Target
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 at the Fed; 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
7
How Traditional 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” (Increases do the opposite.)
How?
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monetary policy works, in part, by influencing longer-term interest rates; Fed influences,but
does not “set,” longer-term interest rates
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the interest rate on a longer term loan is an average of two things, the current short term
rate and the average short term rate currently expected over the term of the loan, plus an
additional amount (premium) that compensates the lender for the pure interest rate risk of
holding a longer-maturity asset and any credit risk of lending to a particular borrower rather
than the Treasury. (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 average of future short term rates, thus affecting 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 average of future short term interest rates--as is usually the case--this would
also lower longer-term rates. (A higher funds rate accompanied by higher expected future
short term rates, in contrast, would raise long term rates.)
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How Traditional Monetary
Policy Works (cont.)
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recent research also suggests that traditional monetary policy also affects the premium(s) in
longer-term rates that compensate the lender for interest rate risk and any credit risk. A
reduction in the funds rate target, and the funds rate, compresses the premium(s), thereby
lowering longer-term rates. (Stein speech 2/21/14) (An increase in the target and actual rate,
in contrast, lifts longer-term rates.) Thus, monetary policy influences all three of the
determinants of longer-term interest rates.
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these effects on longer-term interest rates stimulate borrowing and spending by households
and businesses when longer-term rates fall, and restrain spending when longer-term rates
rise.
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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, the stance of fiscal policy, and the
stage of business cycle, international capital flows…) also affect interest rates, and many
factors other than interest rates (e.g. consumers’ wealth, current income, and confidence
about the future; the availability of credit for consumer and business spending; government
fiscal policies, economic conditions abroad...) affect spending.
9
How Traditional Monetary
Policy Works (end)
Traditional 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.
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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 reduce 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 increase aggregate demand in the U.S.
10
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 “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.
11
Difficulties in Monetary Policy
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monetary policy does not work immediately. It works with a lag, so
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policy cannot be solely based on data (which reflect the recent past, not the future, and, 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 and lowering exchange rates) 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.
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monetary policy has had to contend with shifting “headwinds” ever since the recovery began
in mid-2009. Hence, the relatively slow growth of aggregate demand, despite aggressive
policy easing.
the current headwinds may gradually be abating; if so, the growth of demand will increase
and the recovery will strengthen. (see section on current “headwinds,” below)
12
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 2007-2009 Great Recession--monetary policy can
respond by acting to lower longer-term interest rates, in order to stimulate spending, and to arrest and limit
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.
The U.S. economy and monetary policy have been in this phase of demand expansion 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 that defines price stability.
At some point, as the economy recovers, and demand and actual output approach potential output,
monetary policy will have to change and provide less stimulus to aggregate demand. 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 still sometime in the future.
13
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 expected future house price appreciation, investors’ speculative demand for
housing—including newly produced 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 could sell their
homes for more than they had borrowed to repay their mortgage debts. Borrowsers 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
initially, 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.
15
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.
16
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, slowsing aggregate demand growth.
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 –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.
All this was already underway in summer 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 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.
17
Recent Monetary Policy (cont)
Monetary Policy Responds
From September of 2007 until mid-2009, because of demand shocks, 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 the recession).
From late 2007 until the middle of 2008, the U.S. 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”)
18
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 “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, large scale asset purchases and forward guidance—
communications about the likely future path of the federal funds rate and other policy
measures-- to further lower longer-term interest rates and 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.
19
Recent Monetary Policy (cont)
Initially, the ultra-low federal funds rate, two early versions of forward guidance 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—
helped 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 persistencly on average)--was avoided. Other
governmental policies--including liquidity programs established by the Fed and
related actions by the Treasury, the Federal Deposit Insurance Corporation and
Congress that prevented a collapse in the financial system, and the incoming Obama
Administration’s 2009 fiscal stimulus program--also helped.
In mid-2009, in part because of aggressive monetary policy easing, aggregate demand and
output stopped falling, stabilized, 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. Expansionary monetary
policy supported an earlier, stronger recovery than would have otherwise occurred.
20
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 forward guidance about the likely future path of the federal
funds rate and other policy measures 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 normal
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, again in January 2014, and again in February 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 prevent an unwanted decline in inflation.
21
Recent Monetary Policy (cont)
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Policy today is highly accommodative, and appropriately so. 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 “it likely will be appropriate to
maintain the current target range for the federal funds rate for a considerable time after the
asset purchase program ends, especially if projected inflation continues to run below the
Committee’s 2 percent longer-run goal…” Also, “Even after employment and inflation are
near mandate-consistent levels, economic conditions may, for some time, warrant keeping
the target federal funds rate below levels the Committee views as normal in the longer-run.”
The Fed’s balance sheet has grown sharply, now exceeds $4 trillion in assets, and is still
growing rapidly. Two earlier rounds of large scale asset purchases greatly enlarged the
Fed’s balance sheet; the third, ongoing round of asset purchases is currently adding $55
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 stimulus 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.
22
Recent Monetary Policy (end)
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The unemployment rate, currently at 6.7% (March 2013), remains well above the 5.2% to
6% range of unemployment rates the FOMC believes is consistent with “maximum
employment.” It is expected to gradually decline. Inflation measured by the PCE index is
currently a bit below 1% per year, a figure well below the FOMC’s 2% inflation target.
Inflation is expected to rise gradually over time, but still to remain below 2%, for the next
several years.
23
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 and reassessed 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 increase 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 policy normalization and 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.
24
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 government sponsored entities (GSEs), and Treasury securities. (First
round of LSAPs was dubbed “quantitative easing” by the press—”QE” for short.)

In November 2010, the Fed announced a second round of large scale asset purchases, this
time $600 billion worth of longer-term Treasury securities; it ended in June 2011 (“QE 2” )

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 and Freddie. The total amount to be bought was open-ended, with no
preannounced total amount of purchases. In December 2012, the Fed also began to buy
longer-term Treasury securities 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 and again in March 2014. But the Fed is still adding assets rapidly--$55 bilion/month
25
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. “
26
How LSAPs Work and How
Much(cont.)





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.”
27
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)
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 Committee on Financial Services, 2/11/14)
28
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)
29
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.”
30
Maturity Extension Program




Beginning in August, 2011, and continuing until June 2012, the Federal Reserve sold $400
billion of shorter-term Treasury securities and used the proceeds to buy 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 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 increasing the size of the Federal Reserve’s balance.
31
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”).
32
Forward Guidance
December 2012 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
remained in subsequent FOMC releases until it was dropped in March 2014.
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.
33
Forward Guidance
December 2013--FOMC changes and strengthens forward guidance on 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, then $85 billion per month, 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,“ etc. (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)
These two paragraphs remained the guidance until March 2014, when the FOMC dropped them.
34
Forward Guidance
March 2014 : New (and current) qualitative guidance on the funds rate
By the March 2014 FOMC meeting, the unemployment rate had declined and was close to the
6.5% threshold that the FOMC had said earlier could trigger consideration of starting to increase
the federal funds rate. But much of the improvement in the unemployment rate had been due to
a decline in the labor force participation rate, so the value of the unemployment rate as a
threshold, and as a summary statement of the health of the labor market, had diminished. The
significance of 6.5% had also been diminished by the FOMC’s earlier promise to keep the funds
rate exceptionally low “well past the time” that 6.5% was passed. Moreover, the FOMC felt that
the market wanted more information on the likely timing of funds rate increase, stated in a way
that retained the FOMC’s ability to respond flexibly to incoming information in the future.
These considerations, and a desire to reassure market participants that the Fed was not
planning to raise interest rates any time soon (because the FOMC felt the recovery was still far
from complete) led to the FOMC’s new forward guidance, which links the timing of any future
increase in the funds rate to realized and expected progress in achieving the dual mandate, and
the end of the third round of asset purchases:
35
Forward Guidance
“In determining how long to maintain the current 0 to ¼ percent target range for the federal funds
rate, the Committee will assess progress—both realized and expected—toward its objectives of
maximum employment and 2 percent inflation. This assessment will take into account a wide
range of information, including 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 of the federal funds rate for a considerable time after the
asset purchase program ends, especially if projected inflation continues to run below the
Committee’s 2 percent longer-run goal, and provided that longer term inflation expectations
remain well anchored.
“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.”
The FOMC then added this reassurance regarding the level of future rates: “The Committee
currently anticipates that, even after employment and inflation are near mandate-consistent
levels, economic conditions may, for some time, warrant keeping the target federal funds rate
below levels the Committee views as normal in the longer run” (e.g. below 4% )
36
Forward Guidance
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 agency mortgage backed securities, MBS. Initially, $40
billion of MBS 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 initially said that asset
purchases would continue until there was a substantial improvement in the outlook for the labor
market (italics added) “achieved in a context of price stability”.
Thus, 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.”
37
Forward Guidance
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, starting 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.
38
Forward Guidance
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 decision 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.
39
Forward Guidance
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 and again in March 2014, the FOMC reduced the monthly pace of its asset
purchases by a further $10 billion, each time repeating the statement in the preceding
paragraph.
Going forward, if developments continue to show ongoing improvement in the labor market
outlook and inflation rising toward 2%, the FOMC will likely continue to taper purchases at future
meetings. But changes in that outlook, and in assessments of the efficacy and costs of
purchases, could alter the expected taper path.
40
Current Forward Guidance
In sum, under current guidance about the funds rate target and asset purchases, the FOMC
believes the sequence of future monetary policy changes will likely be:

first, if conditions suggest an ongoing improvement in the outlook for the labor market, and
inflation moving back to the FOMC’s 2% target, as expected, “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, the FOMC will likely then allow a “considerable period” to pass. (Chair Yellen recently
suggested this period might be about six months.) During this time, in line 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, after that period ends, the FOMC could begin to raise the target for the funds rate,
based on an assessment of progress—both realized and expected –toward the objectives of
maximum employment and 2 percent inflation.

fifth, “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.”
41
Current Forward Guidance

Finally, the FOMC currently believes that “even after employment and inflation are near
mandate-consistent levels, economic conditions may, for some time, warrant keeping the
target federal funds rate below levels the Committee views as normal in the longer run.”
42
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 our current 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 first tapering, and later 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.
43
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 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, making similar judgments, the FOMC decided to taper further, starting in
February.
In March 2014, making similar judgments, the FOMC decided to taper further, starting in
April.
44
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, 4/10/14):

The Federal Reserve’s assets have more than quadrupled from $876 billion to $4.24 trillion

composition and average maturity of Fed assets has changed dramatically since mid-2007:




U.S. government securities holdings increased from $790 billion to $2.33 trillion;
holdings of Fannie Mae- and Freddie Mac-guaranteed MBS—not previously held-- have risen sharply, and now total $1.6
trillion. In addition, average maturity of Federal Reserve’s securities holdings has increased via long-term asset purchases
and maturity extension.
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 $2.70
trillion. Nearly all of this is excess reserves – amounts above those necessary to meet
reserve requirements. (Currency outstanding, Fed’s other main liability, now $1.23 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 aggregate demand that could cause future inflation.
45
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.”
46
FOMC Release 3/19/14
“Information received since the Federal Open Market Committee met in January indicates
that growth in economic activity slowed during the winter months, in part reflecting adverse
weather conditions. Labor market indicators were mixed but on balance showed further
improvement. The unemployment rate, however, remains elevated. Household spending
and business fixed investment continued to advance, while the recovery in the housing
sector remained slow. 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 labor market conditions will continue
to improve gradually, moving toward those that the Committee judges consistent with its
dual mandate. The Committee sees the risks to the outlook for the economy and the labor
market as nearly balanced. The Committee recognizes that inflation persistently below its 2
percent objective could pose risks to economic performance, and it is monitoring inflation
developments carefully for evidence that inflation will move back toward its objective over
the medium term.
47
FOMC Release 3/19/14
(cont.)
“The Committee currently judges that there is sufficient underlying strength in the broader
economy to support ongoing improvement in the labor market. In light of the cumulative progress
toward maximum employment and the improvement in the outlook for labor market conditions
since the inception of the current asset purchase program, the Committee decided to make a
further measured reduction in its pace of asset purchases. Beginning in April, the Committee will
add to its holdings of agency mortgage-backed securities at pace of $25 billion per month rather
than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a
pace of $30 billion per month rather than $35 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.
48
FOMC Release 3/19/14
(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.
49
FOMC release 3/19/14 (cont.)
“To support continued progress toward maximum employment and price stability, the Committee
today reaffirmed its view that a highly accommodative stance of monetary policy remains
appropriate. In determining how long to maintain the current 0 to ¼ percent target range for the
Federal funds rate, the Committee will assess progress—both realized and expected—toward its
objectives of maximum employment and 2 percent inflation. This assessment will take into
account a wide range of information, including 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 for a considerable time
after the asset purchase program ends, especially if projected inflation continues to run below
the Committee’s 2 percent longer-run goal, and provided longer-term inflation expectations
remain well anchored.
“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.
The Committee currently anticipates that, even after employment and inflation are near
mandate-consistent levels, economic conditions may, for some time, warrant keeping the target
federal funds rate below levels the committee views as normal in the long run.
50
FOMC Release 3/19/14 (end)
“With the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward
guidance. The change in the Committee’s guidance does not reflect any change in the
Committee’s policy intentions as set forth in its recent statements.”
Statement adopted by a vote of 9-1, President Kocherlakota, FRB Minneapolis, dissenting.
51
“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 easing as well. (e.g. modestly lower average mortgage credit scores last year)
the euro zone, previously in recession, is now growing slowly. In the past, eurozone
conditions have restrained the demand for U.S. exports and the growth of U.S. aggregate
demand. But euro zone and world growth are picking up, so this headwind also abating.
de-leveraging by households has restrained consumer borrowing and spending, but, with
substantial deleveraging now achieved, effects may be abating. (e.g. recent strong growth in
auto 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” has slowed the housing recovery. But residential investment has improved from
a low base, and further improvement is likely.
bad weather that recently restrained retail sales, auto sales, new home construction is over
52
Exit Strategy: Timing





Even with tapering of asset purchases, current monetary policy is highly expansionary, and
appropriately so, with aggregate demand insufficient and growing relatively slowly,
unemployment relatively high and inflation 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 up 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 and/or financial instability).
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.
53
Exit Strategy: Tools
At some point, it will be necessary to “normalize” monetary policy and raise interest rates.
The Fed has the tools needed 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. In theory, 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.
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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?
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First, assuming ongoing “substantial improvement in the outlook for the labor market in a
context of price stability” new monthly asset purchases will gradually diminish and ultimately
end. At that point, Fed will stop adding accommodation. Maintaining the size of its thenexisting asset holdings will maintain accommodation.
After the passage of a “considerable” time, the Fed could consider beginning to withdraw
accommodation, but will do so only based on progress toward meeting both of its dual
mandate goals.
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)
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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.)
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Exit Strategy: Will
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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 the unemployment rate still above its longer-term sustainable
level--making tightening even more unpopular. Tightening will seem premature, and will
likely 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

FOMC releases and minutes, monetary policy testimonies and speeches, H.4.1 release
(Fed’s balance sheet), etc.
Recent monetary policy speeches, testimonies, statements, press conferences and FOMC
minutes:

Chair Yellen, “Monetary Policy and the Economic Recovery,” 4/16/14

Chair Yellen, “What the Federal Reserve is Doing to Promote a Stronger Job Market,“
3/31/14

Chair Yellen, post-FOMC press conference 3/19/14

Chair Yellen, semiannual monetary policy testimony, 2/27/14

Then-Vice Chair Yellen, statement at hearing on her nomination to be Fed Chair, 11/14/13

minutes of the most recent 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
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