U.S. Monetary Policy Since Late Structure of the Federal Reserve System

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1 U.S. Monetary Policy Since Late 2007 Winthrop P. Hambley Senior Adviser February 28, Structure of the Federal Reserve System Board of Governors, Washington D.C. 7 members nominated by the President, confirmed by the U.S. Senate Chair (now, Janet Yellen) and Vice Chair are separately nominated by the President from among Board members, separately confirmed by the Senate. 12 Federal Reserve Banks, each with its own President each Reserve Bank has a nine member board of directors of these nine, the six board members chosen to represent the public nominate the President of their bank (Dodd-Frank Act, 2010) Board of Governors approves or disapproves these nominations Federal Open Market Committee Board members and Reserve Bank Presidents 2 1

2 Federal Open Market Committee (FOMC) key monetary-policy making body of FRS all 7 Board members, all 12 Bank Presidents participate in FOMC discussions of monetary policy all Board members and 5 Bank Presidents (NY Fed President always, other Presidents in rotation) vote at FOMC meetings 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 Transparency monetary policy transparency: decision on funds rate target and other policy actions announced immediately after FOMC meetings, with brief explanation, in FOMC statement/press release. This includes votes by name for or against the policy action; since 12/08 has included forward guidance on likely future policy (see the latest FOMC release, below) minutes of each FOMC meeting released after three weeks (unique among central banks) edited transcripts of FOMC meetings, and all meeting materials, released after five years (unique among central banks) 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 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 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) 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. 4 2

3 Monetary Policy Mandate The Federal Reserve is independent operationally independent--but is not free to do whatever it wants in monetary policy. Instead, constrained discretion. Monetary policy reflects legal mandate established by Congress Since 1977, goals of monetary policy have been established by law: monetary policy is to promote maximum employment, stable prices, and moderate long term interest rates. These terms, equal in statute, are not defined in the law. Now, the dual mandate : Fed is to promote (1) maximum employment and (2) stable prices (if both attained simultaneously, moderate long term interest rates would be achieved automatically real long-term interest rates consistent with full employment, no premium in nominal interest rates for expected future inflation). Most FOMC participants currently believe that the mandate consistent measure of maximum employment is an unemployment rate in the range of 5.2% to 6%. They view an inflation rate of 2% per year, measured by the PCE index, as consistent with their price stability and maximum employment mandates. At times, the two goals in the dual mandate may temporarily conflict, requiring tradeoffs. In the long run, maximum sustainable employment is best achieved by attaining and maintaining price stability. The two goals are ultimately complementary. (See Bernanke, The Benefits of Price Stability, 2/06) 5 Monetary Policy Mandate New Chair Janet Yellen on the dual mandate: I strongly support both parts of the Federal Reserve s dual mandate: price stability and maximum employment. I have led the committee to produce a statement concerning its (the FOMC s ed.) longer-run policy strategies and goals that puts both of these on an equal footing. I strongly support the Federal Reserve s dual mandate, both parts of it. Both price stability and employment matter enormously to American households. I think the dual mandate serves this country well. And there is no conflict, most of the time and especially now, between pursing both pieces of this. I am committed to achieving both parts of our dual mandate helping the economy return to full employment and returning inflation to 2 percent, while ensuring that it does not run persistently above or below that level. -- Yellen testimony at House Financial Services Committee, 2/11/14 6 3

4 Achieving the Targeted Funds Rate: Open Market Operations Open market operations (OMO): Fed purchases, or sells, government securities in the market. OMO are usually a means to an end--achieving a targeted level of the federal funds rate. banks and other depository institutions (DIs) have accounts at their bank, the Fed 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 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 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 if the federal funds rate is above the FOMC s target, the Fed buys government securities from banks (or from primary dealers), and pays by adding to amounts in DIs (or primary dealers banks ) accounts; this increases the supply of federal funds relative to the demand, reducing the funds rate 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 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 Monetary Policy Works ordinarily, reductions in the federal funds rate provide financial stimulus, increase household and business spending and increase aggregate demand in the economy. (Increases do the opposite.) How? monetary policy works, in part, via interest rates; Fed influences, but does not set, most interest rates the interest rate on a longer term loan to a given borrower is an average of the current short term rate and currently expected future short term rates over the term of the loan, plus an additional amount (term premium) compensating the lender for the risk of holding a longer-lived asset. (expectations /term premium theory of term structure of interest rates) traditional monetary policy the funds rate target, open market operations to achieve the target, and how the Fed talks about its policy and the economy--affects both current short term rates and the expected path of future short term rates, and thus affects two of the three determinants of longer term rates a lower funds rate tends to lower other short term interest rates. If also accompanied by a lower expected path of future short term interest rates, this would also lower longer-term rates, stimulating spending by consumers and businesses. (A higher funds rate accompanied by higher expected future short term rates, in contrast, would raise long term rates, and restrain spending by consumers and businesses.) monetary policy is only one influence although an important one-- on interest rates and on spending decisions. Many things other than monetary policy (e.g., changing lender perceptions of credit risk and of the risk of future inflation, stage of business cycle ) also affect interest rates, and many factors other than interest rates affect spending (e.g. consumers wealth, current income, and confidence about the future; the availability of credit to support consumer and business spending; government fiscal policies-- spending and tax policies, economic conditions abroad...) 8 4

5 How Monetary Policy Works Monetary policy also affects spending indirectly by affecting asset prices and wealth, and exchange rates: Monetary policy affects asset prices, including stock prices and house prices, and thus affects household wealth, an important determinant of consumer spending. For example, a reduction in interest rates will reduce discount rates used to evaluate expected future dividends on stocks, and thus will generally be associated with higher stock prices, greater wealth, and increased consumption spending. And if lower long-term interest rates increase borrowing to buy houses, and thereby increase the demand for housing, house prices will also be higher, also increasing wealth and consumption spending. Stock prices are also an important influence on investment spending by businesses; higher stock prices will tend to increase such spending. Monetary policy also affects exchange rates which, in turn, affect U.S. and foreign demand for U.S.- made goods and services. For example, if monetary policy results in lower U.S. interest rates (with foreign interest rates unchanged), the U.S. will be a relatively less attractive place in which to invest. Foreigners wanting to make fewer financial investments in the U.S. will decrease their demand for dollars, which will decrease the price of the dollar in foreign exchange markets. A less expensive U.S. dollar will decrease the price of U.S. goods to foreigners in their own currencies, which will tend to spur foreign demand for U.S. goods. Also, the lower price of the dollar will make it relatively more expensive in dollars for Americans to buy foreign goods, and Americans will switch some of their purchases from now more-expensive imports to now relatively less-expensive U.S. goods and services. Both of these switching effects increase the demand for U.S. produced goods and services, and so tend to increase aggregate demand in the U.S. 9 Monetary Policy Influences Aggregate Demand The key in monetary policy is to use the federal funds rate (or other policy tools) to try to influence longer-term interest rates and, thus, overall spending decisions, and thereby align aggregate demand with U.S. potential output the output the economy could produce if employment was at its maximum sustainable level (or, equivalently, if the unemployment rate was at its lowest sustainable level). (Potential output is not known with certainty, but can be estimated.) Potential output changes over time, and usually grows, so this would involve not only trying to align aggregate demand with (estimated) potential output, but also keeping aggregate demand aligned with and growing with-- this usually growing moving target. The Fed wants to keep demand tracking potential output in a particular way over time: not growing too slowly relative to potential output, which would cause excess supply, making inflation slow or prices fall; and not growing faster than potential output, which would cause demand to outstrip potential output, resulting in excess demand and inflation. It is seeking price stability -- prices that are stable, not rising very much on average, over time. If the Fed does these things, it will achieve both of the goals in its dual mandate. 10 5

6 Responding to Shocks to Aggregate Demand If a shock occurs that depresses aggregate demand below what is necessary to purchase potential output, causing unemployment to rise as happened in the recent Great Recession--monetary policy can respond by acting to lower interest rates, in order to stimulate spending, and to arrest, limit, and ultimately offset the decline in demand. Monetary policy then can help demand to begin increasing, and then increasing faster than the growth of potential output. In that way, monetary policy can help make demand and actual output catch up to potential output, closing the GDP gap and lowering the unemployment rate to a rate consistent with maximum employment. This phase of demand expansion is essentially the situation the U.S. economy and monetary policy have been in since the current recovery began in June Stimulating the growth of demand in this way can also help to prevent an unwanted decline in the rate of inflation below the targeted 2% rate thought consistent with price stability. At some point, as the economy recovers, and demand and actual output approach potential output, monetary policy will have to change and become less stimulative. The purpose of doing this would then be to slow the growth of demand and actual output to the growth of potential output, so as to avoid overshooting potential output and causing excess demand and inflation. While exiting from accommodative policy, interest rates ultimately will have to rise to more normal levels, in order to slow the growth of aggregate demand to the growth of potential output. The exit phase of current monetary policy has not yet begun, and is sometime in the future. 11 Difficulties in Monetary Policy monetary policy works with a lag, so policy cannot be solely based on rear view mirror data (which, in any case, are often revised), but must also be informed by forecasts even if policy has intended effect on interest rates and spending lowering interest rates (and increasing asset prices) to increase the growth of aggregate demand/spending in the current context-- other factors affecting spending may comprise headwinds that work against that effect, tending to slow the growth of aggregate demand. Monetary policy has had to contend with shifting headwinds ever since the recovery began in mid the current headwinds may gradually be abating. (see section on current headwinds, below) 12 6

7 Recent Monetary Policy End of the Housing Boom and the Situation in the Summer of 2007 By the summer of 2007, the housing boom had ended. After a long period of rising housing demand, ever-faster house price increases, and expanding homebuilding, housing demand had stopped growing. House prices had peaked sometime in 2006, ending expected future house price appreciation. (chart, house price index) At that point, homes had simply become too expensive for people to continue to buy, and to borrow to pay for. With the end of house price appreciation, investors speculative demand for housing abruptly shrank. In response, home sales and residential investment spending declined (and later fell much further). Home-building and construction related employment contracted. Thus, initially, residential construction and employment in homebuilding were a weak spot in the real economy, otherwise strong and close to full employment. With an excess supply of housing, and a large and growing inventory of unsold houses, house prices started falling. In the latter part of the housing boom, hybrid 2/28 and 3/27 mortgages had become common. These loans had a fixed rate for the first two or three years. After those introductory periods, their interest rates adjusted upward significantly, and, for the remaining 28 or 27 years varied with movements in an index. This design strongly encouraged borrowers to refinance before rates reset in order to avoid the higher rates. 13 Recent Monetary Policy Because credit had been easily available, and home prices had been increasing, borrowers had thought they could easily refinance existing loans, using the equity that they expected would have built up in their home through rising house prices. Or, if necessary, they thought they could sell their homes for more than they had borrowed to repay their mortgage debts. They expected mortgage credit to continue to be readily available and expected to have built home equity through price appreciation. (Lenders, expecting continued house price appreciation, agreed.) But many of these borrowers had put little or nothing down when they borrowed. And when house prices stopped rising, they were no longer building equity in their homes automatically. Many other borrowers had taken out option ARM mortgage loans, which allowed them to pay only interest--or even less than interest--each month. Having made only such small payments, they had not paid down any principal on their mortgages they had built little or no home equity through their monthly mortgage payments. Still other homeowners had taken out and spent any equity they had, by using cash out refinancing, or by drawing on home equity loans or home equity lines of credit. As a result, many borrowers had little or no--or even negative--home equity. 14 7

8 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. 15 Recent Monetary Policy (cont) With rising mortgage losses, demand for MBS and CDOs, and their prices, declined, causing additional mark-to-market losses for financial institutions and investors that held them. In response, lenders began to tighten the terms and availability of new mortgage credit, and then of other forms of credit, from 2007 on, constraining aggregate demand. All this was already underway in 2007, with the economy near full employment. Policy aimed to prevent a further drop in aggregate demand, which would aggravate underlying problems. If demand dropped, it would increase unemployment and lower incomes, reducing borrowers ability to repay all types of loans, further increasing mortgage (and other) loan losses, further increasing foreclosures and excess housing supply, further reducing home prices and depressing MBS and CDO values more, further damaging financial institutions, causing them to tighten credit even more, further reducing aggregate demand By bolstering aggregate demand, policy aimed to forestall negative feedback loops between the housing and mortgage markets, the financial system, and the macro-economy. At first, in 2007, as investors shunned private label MBS, securitization of subprime mortgages collapsed; later, in late 2008, structured finance in general contracted sharply, making credit for many types of spending CRE, student loans, small business loans, etc.-- less available and more expensive. Securitization suddenly became a far smaller source of credit supporting spending, which had a significant negative impact on aggregate demand. 16 8

9 Recent Monetary Policy (cont) Monetary Policy Responds From September of 2007 until mid-2009, the U.S. economy was weakening relative to its potential. This happened slowly at first, then much more dramatically after mid-2008 and into early (chart, GDP gap) A recession, now called the Great Recession because of its length and depth, began in December of (Shaded area in chart denotes recession). From late 2007 until the middle of 2008, the economy was growing (aggregate demand and actual output were increasing), but more slowly than estimated potential output. A modest gap opened up between actual output and estimated potential output, with actual output below potential. Coincident with the intensification of the financial crisis from 9/08 into early 2009 ( the Great Panic ), aggregate demand and output began to fall in the third quarter of 2008, then fell more rapidly in Q4 of 2008 and Q1of 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 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 (chart, unemployment rate ) 17 Recent Monetary Policy (cont) During this entire period, and continuing to the present, the Fed has aggressively sought to boost the growth of aggregate demand through traditional monetary policy. (chart, federal funds rate target ) In order to counter actual and expected macroeconomic weakness, starting in September of 2007 and continuing until December of 2008, the Fed rapidly reduced its target for the federal funds rate from 5-1/4% to an historically exceptionally low range of 0% to ¼% (nearly 100%). That exceptionally low range for the funds rate remains in place today. Starting in December 2008, deeply worried about the overall economy, the Fed aggressively used two nontraditional tools, including large scale asset purchases and forward guidance enhanced communications about the likely future path of the federal funds rate-- to further lower longer-term interest rates in order provide more stimulus to demand. Although aggregate demand did fall at first, and monetary policy, working with a lag, did not avert a severe recession, aggressive policy easing prevented aggregate demand from being lower, unemployment from being higher, and the housing and mortgage markets and the financial system, from being in far worse condition at each later point in time. 18 9

10 Recent Monetary Policy (cont) Initially, the ultra-low federal funds rate, two early versions of enhanced communication aiming to lower long term interest rates, and the initiation of a first round of large scale asset purchases (see below) to lower term premiums and further lower long term rates combined with liquidity programs established by the Fed and other policies of the federal government that prevented a collapse in the financial system, and also combined with the incoming Obama Administration s 2009 fiscal stimulus program-- stopped an ongoing decline in aggregate demand by mid Consequently, a much more serious recession perhaps a second Great Depression and deflation (prices falling on average peristently)--was avoided. In mid-2009, in part because of aggressive monetary policy easing, aggregate demand and output stopped falling, stabilized, then began rising, and then began to grow more rapidly than potential output. The recession ended in mid- 2009, and the economy began to recover. Demand growth accelerated in the second half of 2009, and the economy registered 3.1% growth in real GDP in The Fed s expansionary monetary policy supported an earlier, stronger recovery than would have otherwise occurred. 19 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: repeated efforts to strengthen communications about the likely future path of the federal funds rate in order to further lower longer term interest rates (see below on forward guidance ); an explicit policy to maintain the size of the Fed s balance sheet, whose purpose was to avoid a passive tightening of policy that would otherwise have resulted from the runoff of maturing assets; a second round of large scale asset purchases (see below); a maturity extension program that aimed at further lowering term premiums and longerterm interest rates (see below) and a third, open-ended, round of large scale purchases of mortgage backed securities and Treasury securities that is still ongoing, albeit at a pace that was reduced in December 2013, and again in January All of these nontraditional policies were undertaken in order to prod demand and output to keep growing fast enough to outpace the growth of potential output, and thus to reduce the GDP gap and lower the unemployment rate to a rate consistent with maximum employment. At times, additional stimulus was also needed to forestall an unwanted decline in inflation

11 Recent Monetary Policy (end) Policy today is highly accommodative. The funds rate is essentially zero, cannot go lower, and has been exceptionally low for more than five years. Aggressive forward guidance currently suggests that the funds rate will not be increased until the unemployment rate falls at least to 6 and 1/2%, and will remain exceptionally low likely well past the time that the unemployment rate declines below 6-1/2%, especially if projected inflation continues to run below the Committee s 2 percent longer-run goal. The Fed s balance sheet has grown sharply, and is still growing rapidly. Two earlier rounds of asset purchases greatly enlarged the Fed s balance sheet; ongoing asset purchases are currently adding $65 billion (earlier, $85 billion) in additional assets each month. The Fed turned virtually all of its short term Treasury assets into longer term assets via maturity extension. All this easing is cumulative one stimulative policy on top of another. Nonetheless, the recovery has been slow and modest because policy has been, and still is, pushing against strong headwinds which have tended to slow the growth of aggregate demand. The unemployment rate, currently at 6.6% (Jan. 2013), remains well above the 5.2% to 6% range of rates believed consistent with maximum employment. It is expected to gradually decline. Annual PCE inflation, currently 1% (Dec. 2013) is well below the FOMC s 2% target. It is expected to gradually rise, but still to remain below 2% for the next several years. 21 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: fosters stronger recovery, increasing employment and output and promotes attainment of maximum employment maintains inflation closer to the FOMC s 2% target guards against downside risks to the economy But potential benefits must be weighed continually against potential costs. Potential Costs of Policy Easing through Lower Longer-Term Rates: could increase expectations of future inflation and actual future inflation could impair market functioning in Treasury or MBS markets enlarged balance sheet could potentially complicate exit strategy 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

12 Large Scale Asset Purchases Starting in late 2008, the Federal Reserve has engaged in three rounds of large scale asset purchases ( LSAPs ): From December 2008 until March of 2010, the Fed bought $1.7 trillion worth of three types of assets: mortgage backed securities (MBS) guaranteed by Fannie Mae and Freddie Mac, debt issued by these entities, and Treasury securities. (First round of LSAPs was called quantitative easing by the press QE for short.) On November 3, 2010, the Fed announced a second round of large scale asset purchases, this time $600 billion worth of longer-term Treasury securities, that continued through June, 2011 ( QE 2 ) 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. Starting in September, 2012, the Fed began to buy $40 billion per month in MBS guaranteed by Fannie Mae and Freddie Mac. Unlike earlier LSAPs/ QE, the total amount to be bought was open-ended, that is, no total amount of purchases was preannounced. In December of 2012, the Fed also began to buy longer-term Treasury securities, initially at a rate of $45 billion per month. Again, the amount to be bought was open-ended. ( QE 3 ). These amounts were each reduced by $5 billion per month starting in January of 2014, and each by a further $5 billion per month In February But the Fed is still adding assets rapidly. 23 How LSAPs Work and How Much 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

13 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. 25 How LSAPs Work and How Much (end) In summary: For the most part, research supports the conclusion that the combination of forward guidance and large-scale asset purchases has helped promote the recovery. For example, changes in guidance appear to shift interest rate expectations, and the preponderance of studies show that asset purchases push down longer-term interest rates and boost asset prices. These changes in financial conditions in turn appear to have provided material support to the economy. (then-chairman Bernanke 1/3/14) New Chair Janet Yellen: I think that quantitative easing, or purchases of securities, did serve to push down mortgage rates, and other longer-term interest rates quite substantially (testimony at House Financial Services Committee, 2/11/14) 26 13

14 Potential Costs of Large Scale Asset Purchases Then-Chairman Bernanke has previously noted that LSAPs (and accommodative policies generally) have potential costs, while noting that those costs have not yet materialized: potential disruption of securities markets by LSAPs but to this point we have seen few if any problems in the markets for Treasury or agency securities. (8/31/12) further expansion of the Fed s balance sheet could reduce public confidence in the Fed s ability to exit smoothly from its accommodative policies at the appropriate time but the expansion of the balance sheet to date has not materially influenced inflation expectations, likely in part because of the great emphasis the Federal Reserve has placed on developing tools to ensure that we can normalize monetary policy when appropriate. (8/31/12) LSAPs, and prolonged low longer-term interest rates, potentially create risks to financial stability. By driving long term yields lower, policy could induce an imprudent reach for yield by some investors who take on more credit risk, duration risk, or leverage, thereby threatening financial stability but little evidence thus far of unsafe buildups of risk or leverage. (8/31/12) Bottom line: To this point we do not see the potential costs of the increased risk-taking as outweighing the benefits. (2/26/13). At the same time, the Federal Reserve is working to address financial stability concerns through increased monitoring, a more systemic approach to supervising financial firms, and reform to make the financial system more resilient. (5/22/13) 27 Potential Costs of Large Scale Asset Purchases (end) The Federal Reserve could incur financial losses due to a rise in interest rates--but Extensive analyses suggest that the odds are strong that the Fed s asset purchases will make money for the taxpayers, reducing the federal deficit and debt. And, of course, to the extent that monetary policy helps strengthen the economy and raise incomes, the benefits for the U.S. fiscal position would be substantial. (8/31/12) Like former Chairman Bernanke, new Fed Chair Yellen views the potential of current monetary policy to create future financial instability as the most serious potential risk. As she stated in testimony at the House Financial Services Committee on February 11, 2014: We recognize that in an environment of low interest rates like we ve had in the United States now for quite some time, there may be an incentive to reach for yield, and that we do have the potential to develop asset bubbles or a buildup of leverage or rapid credit growth or other threats to financial stability. So especially given that our monetary policy is so accommodative, we re highly focused on trying to identify those threats. Broadly speaking, we haven t seen leverage, credit growth, (or) asset prices build to the point where generally I would say that they were at worrisome levels. looking at a range of traditional valuation measures doesn t suggest that asset prices, broadly speaking, are in bubble territory or outside of normal historical ranges

15 Maturity Extension Program Beginning in August, 2011, and ending in June 2012, the Federal Reserve sold $400 billion of shorter-term Treasury securities and bought an equivalent amount of longer-term Treasury securities. This increased the average remaining term to maturity of the Federal Reserve s Treasury securities holdings. This was the Fed s maturity extension program, (MEP). In June 2012, the FOMC extended the MEP until the end of 2012, selling an additional $267 billion in shorter-term Treasury securities and buying more longer-term Treasury securities. By reducing the average maturity of securities held by the public, the MEP puts additional downward pressure on longer-term interest rates and further eases overall financial conditions. (Bernanke 9/4/12). More formally, the MEP took duration and interest rate risk out of the market, making the public willing to hold remaining longer term Treasuries at a higher price and lower yield; spillover effects lowered other interest rates. MEP was done in order to further lower longer term interest rate and further increase aggregate demand. MEP did not change the size of the Federal Reserve s balance sheet. While the composition of its assets shifted toward longer maturities, total assets remained the same. Since, on net, no new assets were bought, no net additional balances were credited to depository institutions either, so the Fed s total liabilities also remained unchanged. MEP was additional stimulus without making the Federal Reserve s balance sheet bigger. 29 Forward Guidance Currently, there are two categories of forward guidance (1) guidance on the likely future path of the federal funds rate and (2) guidance on the likely future course of asset purchases: 1. Forward Guidance on the Federal Funds Rate: Since late 2008, the FOMC has used forward guidance about the likely future of the range for the federal funds rate to encourage the public to believe that the Fed would keep the federal funds rate very low for longer than previously expected. In its press releases, the FOMC stated, successively, that it expected the federal funds rate would remain exceptionally low : for some time (starting in the December 2008 FOMC release) for an extended period (starting in March 2009) at least until mid-2013 (starting in August 2011) at least until late 2014 (starting in January 2012) at least until mid-2015 (starting in September 2012, continued until December 2012). Such communications lowered the expected future path of the funds rate and of other short term rates, and so tended to lower longer term rates (which, recall, are averages of current short term rates and expected future short term rates, plus an additional amount or term premium )

16 Forward Guidance (cont.) 12/12 Changes to Forward Guidance on the Funds Rate: State Contingent Guidance In December, 2012, the FOMC abandoned date-based communications (such as at least until mid-2015 ) about the anticipated future path of the range of the federal funds rate. In a major change, the FOMC then tied the funds rate range to quantitative economic conditions, stating that the Committee then anticipated that its exceptionally low target range for the federal funds rate of 0- ¼ percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee s 2 percent longer-run goal, and longerterm inflation expectations continue to be well-anchored. (emphasis added). This guidance has remained in all subsequent FOMC releases. This quantitative guidance provided information about the objective circumstances under which policy as reflected in the federal funds rate-- could begin to be tightened. But, as Chairman Bernanke then stressed, this statement did not put monetary policy on autopilot. For example, it did not mean that the funds rate target would automatically be increased when the unemployment rate reached 6.5%, only that the FOMC wouldn t consider raising it before then. 31 Forward Guidance (cont.) This guidance on Fed s range for funds rate was intended to be more transparent; previously, the market was not sure of why Fed chose, or changed, the calendar dates in its guidance. Since September 2012, and still today, the FOMC has also stated that it expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. (italics added) As Chairman Bernanke later (2/26/13) said that the guidance also serve(d) to underscore the Committee s intention to maintain accommodation as long as needed to promote a stronger economic recovery with stable prices

17 Forward Guidance (cont.) December 2013 change to forward guidance on the most likely future path of the funds rate: In December 2013, because of substantial cumulative improvement in labor market conditions and in the labor market outlook, the FOMC decided to begin slowing down the monthly pace of its third round of asset purchases, in anticipation of gradually ending purchases. It coupled this decision with stronger forward guidance on the funds rate. After repeating that the FOMC continued to expect that the exceptionally low range of the federal funds rate would remain appropriate at least as long as the unemployment rate exceeded 6-1/2 percent (italics added), the Committee added the following strengthening statement: The Committee now anticipates that it will likely be appropriate to maintain the current target range for the federal funds rate well past the time that unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee s 2 percent longerrun goal. (italics added) The wording in the last two paragraphs remains the current guidance on the funds rate. 33 Forward Guidance (cont.) 2. Forward Guidance on Asset Purchases In September 2012, the FOMC announced a new, third, open-ended round of large scale asset purchases, specifically, purchases of mortgage backed securities, MBS. Initially, $40 billion of such securities would be purchased each month. This announcement was accompanied by a statement setting out qualitative criteria concerning how long the FOMC would continue these MBS purchases. These criteria said that asset purchases would continue until there was a substantial improvement in the outlook for the labor market (emphasis added) achieved in a context of price stability. The initial version of this guidance in the September 2012 FOMC release, stated; If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability

18 Forward Guidance (cont.) In December 2012, the FOMC announced it would begin purchasing longer-term Treasury securities, initially at a rate of $45 billion per month. (These purchases replaced the purchases of longer term Treasuries under the MEP, which was ending, and would be in addition to the ongoing MBS purchases.) The FOMC then repeated its earlier qualitative guidance for asset purchases (after broadening it to include purchases of both Treasury securities and MBS), again stating that If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability. This guidance on asset purchases later evolved into the following form, which still tied the end of the Fed s asset purchases to achieving a substantial improvement in the outlook for the labor market, and also to price stability. As the FOMC stated in September, 2013, The Committee.will continue its purchases of Treasury and agency mortgage backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. (emphasis added) This statement remains in the most recent FOMC releases. 35 Forward Guidance (cont.) The FOMC explained how it will decide when to start tapering its asset purchases in the release following its September and October 2013 meetings: In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee s decisions about their pace will remain contingent on the Committee s economic outlook as well as its assessment of the likely efficacy and costs of such purchases. At its December 2013 meeting, the FOMC began to reduce the pace of its asset purchases from $85 billion per month to $75 billion per month. That reflected a judgment that by then there had finally been both substantial cumulative progress in actual labor market conditions and a substantial improvement in the outlook for the labor market

19 Forward Guidance (cont.) In December 2013, when announcing its decision to reduce the monthly rate of its asset purchases by $10 billion, the FOMC added the following statement about the likely future course of asset purchases: If incoming information broadly supports the Committee s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee s decisions about their pace will remain contingent on the Committee s outlook for the labor market and inflation, as well as its assessment of the likely efficacy and costs of such purchases. In January 2014, the FOMC reduced the monthly pace of its asset purchases by a further $10 billion, and repeated the statement in the preceding paragraph. Thus, going forward, if developments continue to show ongoing improvement in labor market conditions and in the labor market outlook and inflation rising toward 2%, the FOMC will likely continue to taper purchases at future meetings. 37 Forward Guidance (cont.) In sum, now that the Fed has begun to taper its asset purchases, under current guidance about the funds rate target and asset purchases, the sequence of future monetary policy changes will likely be: first, if conditions suggest an ongoing improvement in labor market conditions and in the future outlook for the labor market, and inflation moving back to the FOMC s 2% target, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. second, ultimately, the FOMC will end new asset purchases; the stock of Fed assets will peak third, it will then allow a considerable time to pass after the asset purchase program ends and the economic recovery strengthens. During this time, consistent with current policy, the Fed would maintain the size of its balance sheet by reinvesting proceeds of any securities that mature in new securities. This would maintain downward pressure on interest rates. fourth, when the unemployment rate falls to 6.5%--closer to its sustainable long run normal level and provided the projected inflation rate then was no higher than 2.5%--the FOMC could consider starting to remove monetary policy accommodation by increasing the targeted range for the funds rate

20 Forward Guidance (end) however, fifth, the FOMC currently expects that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee s 2 percent objective. (italics added) finally, When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with it longer-run goals of maximum employment and inflation of 2 percent. 39 The Timing of Tapering At his press conference on June 19, 2013, Chairman Bernanke said the Federal Reserve might start to reduce its then-current round of large scale asset purchases later this year, and end them around the middle of 2014, provided the economy followed the path of moderate recovery then forecast by the Fed. He stated: If the incoming data are broadly consistent with this forecast, the (Federal Open Market) Committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year. If the subsequent data remain broadly aligned with outrcurrent expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year. Thus, LSAPs would end mid This possible timeline for tapering, and then ending, asset purchases, was dependent on the Fed s forecasts, and on the evolution of the economy over time being broadly aligned with the Fed s expectations. The actual timeline for tapering, then ending, asset purchases was always (and still is) data dependent it depended on the state of the economy in the future, as reflected in data then available, and how it compared to forecasted outcomes