Monetary Policy since the Onset of the Crisis
When we convened in Jackson Hole in August 2007, the Federal Open Market Committee’s (FOMC) target for the federal funds rate was 5-1/4 percent. Sixteen months later, with the financial crisis in full swing, the FOMC had lowered the target for the federal funds rate to nearly zero, thereby entering the unfamiliar territory of having to conduct monetary policy with the policy interest rate at its effective lower bound. The unusual severity of the recession and ongoing strains in financial markets made the challenges facing monetary policymakers all the greater.
Today I will review the evolution of U.S. monetary policy since late 2007. My focus will be the Federal Reserve’s experience with nontraditional policy tools, notably those based on the management of the Federal Reserve’s balance sheet and on its public communications. I’ll discuss what we have learned about the efficacy and drawbacks of these less familiar forms of monetary policy, and I’ll talk about the implications for the Federal Reserve’s ongoing efforts to promote a return to maximum employment in a context of price stability.
Monetary Policy in 2007 and 2008
When significant financial stresses first emerged, in August 2007, the FOMC responded quickly, first through liquidity actions–cutting the discount rate and extending term loans to banks–and then, in September, by lowering the target for the federal funds rate by 50 basis points. 1 As further indications of economic weakness appeared over subsequent months, the Committee reduced its target for the federal funds rate by a cumulative 325 basis points, leaving the target at 2 percent by the spring of 2008.
The Committee held rates constant over the summer as it monitored economic and financial conditions. When the crisis intensified markedly in the fall, the Committee responded by cutting the target for the federal funds rate by 100 basis points in October, with half of this easing coming as part of an unprecedented coordinated interest rate cut by six major central banks. Then, in December 2008, as evidence of a dramatic slowdown mounted, the Committee reduced its target to a range of 0 to 25 basis points, effectively its lower bound. That target range remains in place today.
Despite the easing of monetary policy, dysfunction in credit markets continued to worsen. As you know, in the latter part of 2008 and early 2009, the Federal Reserve took extraordinary steps to provide liquidity and support credit market functioning, including the establishment of a number of emergency lending facilities and the creation or extension of currency swap agreements with 14 central banks around the world.2 In its role as banking regulator, the Federal Reserve also led stress tests of the largest U.S. bank holding companies, setting the stage for the companies to raise capital. These actions–along with a host of interventions by other policymakers in the United States and throughout the world–helped stabilize global financial markets, which in turn served to check the deterioration in the real economy and the emergence of deflationary pressures.
Unfortunately, although it is likely that even worse outcomes had been averted, the damage to the economy was severe. The unemployment rate in the United States rose from about 6 percent in September 2008 to nearly 9 percent by April 2009–it would peak at 10 percent in October–while inflation declined sharply. As the crisis crested, and with the federal funds rate at its effective lower bound, the FOMC turned to nontraditional policy approaches to support the recovery.
As the Committee embarked on this path, we were guided by some general principles and some insightful academic work but–with the important exception of the Japanese case–limited historical experience. As a result, central bankers in the United States, and those in other advanced economies facing similar problems, have been in the process of learning by doing. I will discuss some of what we have learned, beginning with our experience conducting policy using the Federal Reserve’s balance sheet, then turn to our use of communications tools.
Balance Sheet Tools
In using the Federal Reserve’s balance sheet as a tool for achieving its mandated objectives of maximum employment and price stability, the FOMC has focused on the acquisition of longer-term securities–specifically, Treasury and agency securities, which are the principal types of securities that the Federal Reserve is permitted to buy under the Federal Reserve Act.3 One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors’ portfolios.4 For example, some institutional investors face regulatory restrictions on the types of securities they can hold, retail investors may be reluctant to hold certain types of assets because of high transactions or information costs, and some assets have risk characteristics that are difficult or costly to hedge.
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 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. Following this logic, Tobin suggested that purchases of longer-term securities by the Federal Reserve during the Great Depression could have helped the U.S. economy recover despite the fact that short-term rates were close to zero, and Friedman argued for large-scale purchases of long-term bonds by the Bank of Japan to help overcome Japan’s deflationary trap.5
Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about “tail” risks such as deflation. During stressful periods, asset purchases may also improve the functioning of financial markets, thereby easing credit conditions in some sectors.
With the space for further cuts in the target for the federal funds rate increasingly limited, in late 2008 the Federal Reserve initiated a series of large-scale asset purchases (LSAPs). In November, the FOMC announced a program to purchase a total of $600 billion in agency MBS and agency debt.6 In March 2009, the FOMC expanded this purchase program substantially, announcing that it would purchase up to $1.25 trillion of agency MBS, up to $200 billion of agency debt, and up to $300 billion of longer-term Treasury debt.7 These purchases were completed, with minor adjustments, in early 2010.8 In November 2010, the FOMC announced that it would further expand the Federal Reserve’s security holdings by purchasing an additional $600 billion of longer-term Treasury securities over a period ending in mid-2011.9
About a year ago, the FOMC introduced a variation on its earlier purchase programs, known as the maturity extension program (MEP), under which the Federal Reserve would purchase $400 billion of long-term Treasury securities and sell an equivalent amount of shorter-term Treasury securities over the period ending in June 2012.10 The FOMC subsequently extended the MEP through the end of this year.11 By reducing the average maturity of the securities held by the public, the MEP puts additional downward pressure on longer-term interest rates and further eases overall financial conditions.
How effective are balance sheet policies? After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. For example, 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 $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.12 Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield.13 These effects are economically meaningful.
Importantly, the effects of LSAPs do not appear to be confined to longer-term Treasury yields. Notably, LSAPs have been found to be associated with significant declines in the yields on both corporate bonds and MBS.14 The first purchase program, in particular, has been linked to substantial reductions in MBS yields and retail mortgage rates. 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. This effect is potentially important because stock values affect both consumption and investment decisions.
While there is substantial evidence that the Federal Reserve’s asset purchases have lowered longer-term yields and eased broader financial conditions, obtaining precise estimates of the effects of these operations on the broader economy is inherently difficult, as the counterfactual–how the economy would have performed in the absence of the Federal Reserve’s actions–cannot be directly observed. If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the 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.15 The Bank of England has used LSAPs in a manner similar to that of the Federal Reserve, so it is of interest that researchers have found the financial and macroeconomic effects of the British programs to be qualitatively similar to those in the United States.16
To be sure, these estimates of the macroeconomic effects of LSAPs should be treated with caution. It is likely that the crisis and the recession have attenuated some of the normal transmission channels of monetary policy relative to what is assumed in the models; for example, restrictive mortgage underwriting standards have reduced the effects of lower mortgage rates. Further, the estimated macroeconomic effects depend on uncertain estimates of the persistence of the effects of LSAPs on financial conditions.17 Overall, however, a balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks.
Now I will turn to our use of communications tools.
Clear communication is always important in central banking, but it can be especially important when economic conditions call for further policy stimulus but the policy rate is already at its effective lower bound. In particular, forward guidance that lowers private-sector expectations regarding future short-term rates should cause longer-term interest rates to decline, leading to more accommodative financial conditions.18
The Federal Reserve has made considerable use of forward guidance as a policy tool.19 From March 2009 through June 2011, the FOMC’s postmeeting statement noted that economic conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”20 At the August 2011 meeting, the Committee made its guidance more precise by stating that economic conditions would likely warrant that the federal funds rate remain exceptionally low “at least through mid-2013.”21 At the beginning of this year, the FOMC extended the anticipated period of exceptionally low rates further, to “at least through late 2014,” guidance that has been reaffirmed at subsequent meetings.22 As the language indicates, this guidance is not an unconditional promise; rather, it is a statement about the FOMC’s collective judgment regarding the path of policy that is likely to prove appropriate, given the Committee’s objectives and its outlook for the economy.
The views of Committee members regarding the likely timing of policy firming represent a balance of many factors, but the current forward guidance is broadly consistent with prescriptions coming from a range of standard benchmarks, including simple policy rules and optimal control methods.23 Some of the policy rules informing the forward guidance relate policy interest rates to familiar determinants, such as inflation and the output gap. But a number of considerations also argue for planning to keep rates low for a longer time than implied by policy rules developed during more normal periods. These considerations include the need to take out insurance against the realization of downside risks, which are particularly difficult to manage when rates are close to their effective lower bound; the possibility that, because of various unusual headwinds slowing the recovery, the economy needs more policy support than usual at this stage of the cycle; and the need to compensate for limits to policy accommodation resulting from the lower bound on rates.24
Has the forward guidance been effective? It is certainly true that, over time, both investors and private forecasters have pushed out considerably the date at which they expect the federal funds rate to begin to rise; moreover, current policy expectations appear to align well with the FOMC’s forward guidance. To be sure, the changes over time in when the private sector expects the federal funds rate to begin firming resulted in part from the same deterioration of the economic outlook that led the FOMC to introduce and then extend its forward guidance. But the private sector’s revised outlook for the policy rate also appears to reflect a growing appreciation of how forceful the FOMC intends to be in supporting a sustainable recovery. For example, since 2009, forecasters participating in the Blue Chip survey have repeatedly marked down their projections of the unemployment rate they expect to prevail at the time that the FOMC begins to lift the target for the federal funds rate away from zero. Thus, the Committee’s forward guidance may have conveyed a greater willingness to maintain accommodation than private forecasters had previously believed.25 The behavior of financial market prices in periods around changes in the forward guidance is also consistent with the view that the guidance has affected policy expectations.26
Making Policy with Nontraditional Tools: A Cost-Benefit Framework
Making monetary policy with nontraditional tools is challenging. In particular, our experience with these tools remains limited. In this context, the FOMC carefully compares the expected benefits and costs of proposed policy actions.
The potential benefit of policy action, of course, is the possibility of better economic outcomes–outcomes more consistent with the FOMC’s dual mandate. In light of the evidence I discussed, it appears reasonable to conclude that nontraditional policy tools have been and can continue to be effective in providing financial accommodation, though we are less certain about the magnitude and persistence of these effects than we are about those of more-traditional policies.
The possible benefits of an action, however, must be considered alongside its potential costs. I will focus now on the potential costs of LSAPs.
One possible cost of conducting additional LSAPs is that these operations could impair the functioning of securities markets. As I noted, the Federal Reserve is limited by law mainly to the purchase of Treasury and agency securities; the supply of those securities is large but finite, and not all of the supply is actively traded. Conceivably, if the Federal Reserve became too dominant a buyer in certain segments of these markets, trading among private agents could dry up, degrading liquidity and price discovery. As the global financial system depends on deep and liquid markets for U.S. Treasury securities, significant impairment of those markets would be costly, and, in particular, could impede the transmission of monetary policy. For example, market disruptions could lead to higher liquidity premiums on Treasury securities, which would run counter to the policy goal of reducing Treasury yields. However, although market capacity could ultimately become an issue, to this point we have seen few if any problems in the markets for Treasury or agency securities, private-sector holdings of securities remain large, and trading among private market participants remains robust.
A second potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability. It is noteworthy, however, that the expansion of the balance sheet to date has not materially affected 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, even if our securities holdings remain large. In particular, the FOMC will be able to put upward pressure on short-term interest rates by raising the interest rate it pays banks for reserves they hold at the Fed. Upward pressure on rates can also be achieved by using reserve-draining tools or by selling securities from the Federal Reserve’s portfolio, thus reversing the effects achieved by LSAPs. The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.
A third cost to be weighed is that of risks to financial stability. For example, some observers have raised concerns that, by driving longer-term yields lower, nontraditional policies could induce an imprudent reach for yield by some investors and thereby threaten financial stability. Of course, one objective of both traditional and nontraditional policy during recoveries is to promote a return to productive risk-taking; as always, the goal is to strike the appropriate balance. Moreover, a stronger recovery is itself clearly helpful for financial stability. In assessing this risk, it is important to note that the Federal Reserve, both on its own and in collaboration with other members of the Financial Stability Oversight Council, has substantially expanded its monitoring of the financial system and modified its supervisory approach to take a more systemic perspective. We have seen little evidence thus far of unsafe buildups of risk or leverage, but we will continue both our careful oversight and the implementation of financial regulatory reforms aimed at reducing systemic risk.
A fourth potential cost of balance sheet policies is the possibility that the Federal Reserve could incur financial losses should interest rates rise to an unexpected extent. Extensive analyses suggest that, from a purely fiscal perspective, the odds are strong that the Fed’s asset purchases will make money for the taxpayers, reducing the federal deficit and debt.27 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. In any case, this purely fiscal perspective is too narrow: Because Americans are workers and consumers as well as taxpayers, monetary policy can achieve the most for the country by focusing generally on improving economic performance rather than narrowly on possible gains or losses on the Federal Reserve’s balance sheet.
In sum, both the benefits and costs of nontraditional monetary policies are uncertain; in all likelihood, they will also vary over time, depending on factors such as the state of the economy and financial markets and the extent of prior Federal Reserve asset purchases. Moreover, nontraditional policies have potential costs that may be less relevant for traditional policies. For these reasons, the hurdle for using nontraditional policies should be higher than for traditional policies. At the same time, the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant.
Read more: FRB Press Release
Franklin Resources, Inc. acquired San Francisco-based Random Forest Capital, LLC, an investment firm with expertise in data science and non-bank marketplace lending (areas of consumer, residential and commercial credit). Random Forest Capital was formed in 2016 and post-deal will join the Franklin Templeton Fixed Income Group investment team. In April 2017, Random Forest completed its seed round raising US$ 1.75 million from a pool of angel investors. Random Forest is co-founded by Austin D. Trombley, who worked on the data infrastructure and data strategy for online lender Prosper for two years. [ Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view content. ]
Singapore’s GIC Private joined other investors in a £100 million round to invest in U.K.-based Oxford Nanopore Technologies Limited (ONT). Other investors in the round include China Construction Bank International (through CCB International (Holdings) Limited), Australian superannuation fund HostPlus (invested £11 million) and Oxford Nanopore’s existing investors. [ Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view content. ]
The Qatar Investment Authority (QIA) continues to realign its private holding portfolio. QIA is looking to sell its holdings in Lifestyle International Holdings Ltd., a Hong Kong-based retailer and its China affiliate unit Lifestyle China Group Ltd. [ Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view content. ]
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