EMBARGOED UNTIL WEDNESDAY, JANUARY 13, 2016 AT 8:20 A.M. EASTERN TIME OR UPON DELIVERY Early Observations on Gradual Monetary Policy Normalization Eric S. Rosengren President & CEO Federal Reserve Bank of Boston January 13, 2016 Greater Boston Chamber of Commerce Boston, Massachusetts bostonfed.org
Improvements in the U.S. Economy Recent employment report 292,000 jobs added in December 284,000 jobs added per month over the past quarter Unemployment rate remained at 5 percent People previously not in the labor force are entering the labor force Tighter labor markets have helped reduce unemployment in some segments that still have elevated unemployment rates 2
Not All Good News Weakness since the New Year Stock markets in much of the world began the year on a decidedly weak note particularly China Weak oil and commodity prices Analyst estimates of Q4 real GDP have been declining Monetary policy should not overreact to shortterm, temporary fluctuations in financial markets But we do need to take seriously potential downside risks to economic forecasts and manage those risks as we think about the appropriate path for monetary policy 3
Overview of My Comments Today The Fed raised short-term rates last month, reflecting the significant progress of the U.S. economy over the last year The initial monetary policy tightening was rather uneventful The effective federal funds rate has largely traded within the new target range Other short-term rates in the marketplace have moved up as expected The future path of the federal funds rate will depend on incoming economic data and likely be gradual I hope the improvement continues, so further normalization is appropriate but it is important to carefully manage risks 4
The Beginning of Monetary Policy Normalization Unemployment rate started 2015 at 5.7 percent and fell to 5.0 percent 2.65 million jobs created in 2015 In December the FOMC raised the federal funds target range: set a new target range of 0.25 to 0.50 percent The federal funds rate has tended to trade in the market around 0.36 percent, about the middle of the new target range 5
This Time is Somewhat Different Very high level of reserves in the banking system (resulting from the Fed s necessary, effective, but extraordinary accommodation post-crisis) Core inflation has yet to show a clear movement towards the Federal Reserve s 2 percent target lack of significant inflationary pressures in the U.S. and weakness in many parts of the world Real GDP is projected to grow only somewhat faster than potential Monetary policy will likely move more gradually than in past tightening cycles 6
Figure 1: Federal Reserve System Assets and Excess Reserves of Depository Institutions in the U.S. January 2000 - December 2015 5 4 Trillions of Dollars Federal Reserve System Assets Excess Reserves 3 2 1 0 Jan-2000 Jan-2005 Jan-2010 Jan-2015 Recession Source: Federal Reserve Board, NBER, Haver Analytics 7
Changes in Monetary Policy Implementation Pre-crisis: Monetary policy set the federal funds rate, a short-term interest rate on overnight loans between banks Because the amount of reserves in the system was relatively modest, small purchases and sales by the Fed s open market desk were sufficient to alter the target (and actual) federal funds rate In response to the crisis: Fed lowered the federal funds rate to effectively zero Deployed new policy tools purchasing securities 8
Figure 2: Federal Reserve System Asset Composition December 28, 2005 and December 30, 2015 5 Trillions of Dollars Other Assets 4 3 2 1 0 December 28, 2005 December 30, 2015 Mortgage-Backed Securities Maturing in More Than 10 Years Treasury Securities Maturing in More Than 10 Years Treasury Securities Maturing in 5 to 10 Years Treasury Securities Maturing in 1 to 5 Years Treasury Securities Maturing in 1 Year or Less Source: Federal Reserve Board, Haver Analytics 9
Figure 3: Excess Reserves of Depository Institutions in the U.S. and the Federal Funds Rate January 2000 - December 2015 4 Trillions of Dollars Excess Reserves (Left Scale) Percent 8 3 Federal Funds Rate (Right Scale) 6 2 4 1 2 0 Jan-2000 Jan-2005 Jan-2010 Jan-2015 Recession 0 Source: Federal Reserve Board, NBER, Haver Analytics 10
Post-Crisis: Large balance sheet, large supply of bank reserves Usual way of raising the federal funds rate is not available: no modest sale of securities will remove enough excess reserves from the system to tighten borrowing conditions in the overnight federal funds market Need new tools to set the top and the bottom of the federal funds target range 11
New Tool Interest on Reserves Congress gave the Federal Reserve the authorization to pay interest on reserves, effective October of 2008 Banks receive interest on reserves held overnight with the Federal Reserve An important tool as the Fed works to raise rates, because banks will not want to lend at a rate below what they can get from holding funds with the Fed Only banks hold reserves and can receive interest on reserves Arbitrage plays a role if overnight rates fall too far below the interest on reserves, banks can make money by buying overnight funds below the interest on reserves and holding those funds at the Federal Reserve where they earn the interest on reserves 12
New Tool Reverse Repurchase Agreement Rate Purchase funds from non-banks at a rate slightly below interest on reserves Currently at a rate of 0.25 percent Collateralized, and transacted with the central bank, so investors should be unwilling to lend at a lesser rate Federal funds should trade in the range between interest on reserves and the reverse repurchase rate 13
Figure 4: Interest on Reserves, the FRB Overnight Reverse Repurchase Rate, and the Federal Funds Rate December 1, 2015 - January 11, 2016 0.60 Percent 0.50 0.40 0.30 0.20 Interest Rate Paid on Reserves 0.10 Federal Funds Rate ON Reverse Repurchase Rate 0.00 01-Dec-15 10-Dec-15 21-Dec-15 30-Dec-15 08-Jan-16 Note: Currently, the interest rate paid on required and excess reserves is the same. Source: Federal Reserve Bank of New York, Federal Reserve Board, Haver Analytics 14
Figure 5: FRB Overnight Reverse Repurchase Agreements: Total Amount Accepted January 2, 2015 - January 11, 2016 500 Billions of Dollars 400 300 200 100 0 02-Jan-15 30-Mar-15 23-Jun-15 16-Sep-15 10-Dec-15 Note: Includes only fixed-rate, one-day reverse repurchase agreements. Source: Federal Reserve Bank of New York, Haver Analytics 15
Figure 6: Selected Short-Term Interest Rates December 1, 2015 - January 11, 2016 0.60 0.50 Percent December 16th 0.40 0.30 0.20 1-Month Eurodollar Deposit Rate 0.10 1-Month LIBOR 1-Month AA Nonfinancial Commercial Paper Rate 0.00 01-Dec-15 10-Dec-15 21-Dec-15 30-Dec-15 08-Jan-16 Source: Federal Reserve Board, Intercontinental Exchange (ICE), Haver Analytics 16
Figure 7: Selected Long-Term Interest Rates December 1, 2015 - January 11, 2016 5 4 Percent December 16th 3 2 1 30-Year Fixed-Rate Mortgage Rate 48-Month New Car Loan Rate 10-Year Treasury Yield 0 01-Dec-15 10-Dec-15 21-Dec-15 30-Dec-15 08-Jan-16 Source: Federal Reserve Board, WSJ, Haver Analytics 17
Figure 8: Treasury Yield Curves January 4, 2006 and January 4, 2016 6 Percent 5 4 3 2 1 0 January 4, 2006 January 4, 2016 0 1 2 3 4 5 6 7 8 9 10 Maturity in Years Source: U.S. Department of the Treasury 18
FOMC Statement, December 16, 2015 The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings and it anticipates doing so until normalization of the level of the federal funds rate is well under way. 19
Reinvestment Strategy Move short-term interest rates first, because we have greater confidence in the likely effects of such a move on the economy Desirable to have the flexibility to respond if necessary to a large unexpected negative shock by reducing short-term rates Reducing the size of our balance sheet would be a form of tightening, with more impact on longer-term rates 20
Figure 9: Unemployment Rate Projections of Federal Reserve Governors and Federal Reserve Bank Presidents, December 16, 2015 2015:Q4-2018:Q4 5.2 5.1 5.0 Percent Central Tendency Median 4.9 4.8 4.7 4.6 4.5 4.4 2015:Q4 2016:Q4 2017:Q4 2018:Q4 Note: The central tendency excludes the three highest and three lowest projections in each period. Source: FOMC, Summary of Economic Projections (SEP), December 16, 2015 21
Figure 10: Civilian Unemployment Rate and the Natural Rate of Long-Term Unemployment 1960:Q1-2015:Q4 12 Percent 9 6 3 Natural Rate of Long-Term Unemployment Civilian Unemployment Rate (U-3) 0 1960:Q1 1969:Q1 1978:Q1 1987:Q1 1996:Q1 2005:Q1 2014:Q1 Recession Source: BLS, CBO, NBER, Haver Analytics 22
Figure 11: U.S. Inflation Rate: Change in Core Personal Consumption Expenditures Price Index January 1994 - November 2015 3 Percent Change from Year Earlier 2% Inflation Target 2 1 0 Jan-1994 Jan-1999 Jan-2004 Jan-2009 Jan-2014 Recession Source: BEA, NBER, Haver Analytics 23
Figure 12: Core Inflation Rate Projections of Federal Reserve Governors and Federal Reserve Bank Presidents, December 16, 2015 2015:Q4-2018:Q4 2.5 Percent Change from Year Earlier 2.0 1.5 1.0 0.5 Central Tendency Median 0.0 2015:Q4 2016:Q4 2017:Q4 2018:Q4 Note: The central tendency excludes the three highest and three lowest projections in each period. Source: FOMC, Summary of Economic Projections (SEP), December 16, 2015 24
Figure 13: U.S. Federal Funds Rate Projections of Federal Reserve Governors and Federal Reserve Bank Presidents, December 16, 2015 December 31, 2015 - December 31, 2018 4.5 4.0 Percent Median Observation 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Year-end 2015 Year-end 2016 Year-end 2017 Year-end 2018 Source: FOMC, Summary of Economic Projections (SEP), December 16, 2015 25
Concluding Observations The initial increase in short-term rates was rather uneventful The Federal Reserve s target rate moved as expected Other short-term rates have moved as expected Further increases in rates are in my view likely to be gradual I remain highly attentive to foreign economic conditions, any weakening of the domestic economic situation, and the path of U.S. inflation 26