EMBARGOED UNTIL WEDNESDAY, APRIL 19 AT 12:30 P.M.; OR UPON DELIVERY The Federal Reserve Balance Sheet and Monetary Policy Eric S. Rosengren President & CEO Federal Reserve Bank of Boston April 19, 2017 26th Annual Hyman P. Minsky Conference Levy Economics Institute of Bard College Annandale-on-Hudson, New York bostonfed.org
The Federal Reserve Balance Sheet and the Economy As the economy has improved, there has been increased attention to the size of the Fed s balance sheet Unemployment, at 4.5 percent, is below many estimates of full employment Total PCE inflation is fluctuating around 2 percent The balance sheet was an important tool for this recovery Deployed when constrained from further reductions by the zero boundary By purchasing assets and increasing the size of the Fed s balance sheet, long-term rates could be reduced Provided additional, needed stimulus 2
Role of Expanded Balance Sheet Some have suggested use of the balance sheets to be limited solely as a response to severe economic conditions My view: structural changes in the macroeconomy may necessitate more frequent use of large-scale asset purchases during recessions Low inflation, low rates of productivity growth, and slow population growth may imply an economy where normal rates remain relatively low by historical standards 3
Future Use of the Balance Sheet The median forecast of Fed policymakers in March was that in the longer run, the federal funds rate was likely to be only 3 percent During most of the previous economic downturns, the Federal Reserve has reduced interest rates by substantially more than 300 basis points As a result, short-term rates may have to be lowered again to zero in response to future recessions, and the central bank may need to again deploy its balance sheet in order to augment traditional policy 4
The Balance Sheet as a Secondary Tool Central banks have significant historical experience with moving short-term interest rates to achieve macroeconomic objectives It makes sense to continue to use short-term interest rates as the primary tool for monetary policy Implications for balance-sheet reduction, in my view: An ideal policy would take a very gradual approach That process could begin relatively soon The tightening of short-term interest rates should not need to be much different than it would be in the absence of shrinking the balance sheet 5
Figure 1: Overnight/Policy Rates for the Euro Area, Japan, and the U.S. January 2000 - March 2017 8 6 Percent U.S. - Federal Funds Target Rate Euro Area - Main Refinancing Rate Japan - Uncollateralized Overnight Call Rate 4 2 0-2 Jan-2000 Jan-2005 Jan-2010 Jan-2015 Note: Rates are as of end of period. U.S. target rate is the midpoint of the target range, beginning in December 2008. Source: Bank of Japan, European Central Bank, Federal Reserve Board, Haver Analytics 6
Figure 2: Central Bank Assets January 2000 - March 2017 800 600 Index, January 2000 = 100 U.S. Japan Euro Area 400 200 0 Jan-2000 Jan-2005 Jan-2010 Jan-2015 Source: Bank of Japan, European Central Bank, Federal Reserve Board, Haver Analytics 7
Figure 3: Central Bank Assets as a Share of GDP 2000:Q1-2016:Q4 100 75 Percent Japan Euro Area U.S. 50 25 0 2000:Q1 2004:Q1 2008:Q1 2012:Q1 2016:Q1 Source: Bank of Japan, Cabinet Office of Japan, European Central Bank, Eurostat, Federal Reserve Board, BEA, Haver Analytics 8
Figure 4: Ten-Year Government Bond Yields January 2000 - March 2017 8 6 4 Percent U.S. France Germany Japan 2 0-2 Jan-2000 Jan-2005 Jan-2010 Jan-2015 Source: Banque de France; Deutsche Bundesbank; Federal Reserve Board; Ministry of Finance, Japan; Haver Analytics 9
Figure 5: Forecasts for the Longer-Run Federal Funds Rate from the Summary of Economic Projections January 2012 - March 2017 5 Percent 4 3 Central Tendency Median Federal Funds Target Rate 2 Jan-2012 Dec-2012 Dec-2013 Dec-2014 Dec-2015 Dec-2016 Date of Forecast Note: The central tendency excludes the three highest and three lowest observations. Source: FOMC, Summary of Economic Projections (SEP) 10
Figure 6: Federal Funds Effective Rate, Noting Peaks and Troughs January 1960 - March 2017 20 Percent 19.10 17.61 15 12.92 10 9.19 9.85 9.03 6.54 5 4.61 5.85 5.26 3.29 2.92 1.17 0.07 0.98 0 Jan-1960 Jan-1970 Jan-1980 Jan-1990 Jan-2000 Jan-2010 Recession Source: Federal Reserve Board, NBER, Haver Analytics 11
Figure 7: Federal Funds Effective Rate: Declines from Peak to Trough January 1960 - March 2017 NBER Peak Decline (Percentage Points) Dates of Decline Federal Funds Rate (%) High Low Apr 1960 2.83 Nov 1959 - Jul 1961 4.00 1.17 Dec 1969 5.90 Aug 1969 - Feb 1972 9.19 3.29 Nov 1973 8.31 Jul 1974 - Jan 1977 12.92 4.61 Jan 1980 8.58 Apr 1980 - Jul 1980 17.61 9.03 Jul 1981 13.25 Jun 1981 - Oct 1986 19.10 5.85 Jul 1990 6.93 Mar 1989 - Dec 1992 9.85 2.92 Mar 2001 5.56 Jul 2000 - Dec 2003 6.54 0.98 Dec 2007 5.19 Jul 2007 - Jul 2011 5.26 0.07 Source: Federal Reserve Board, NBER, Haver Analytics 12
Figure 8: Real Federal Funds Effective Rate, Noting Peaks and Troughs January 1960 - March 2017 12 Percent 9 8.74 10.27 6 4.50 6.55 5.50 4.82 3 1.96 2.53 3.30 0-3 -0.10-1.31-0.10 0.12-0.99-2.01-4.42-6 Jan-1960 Jan-1970 Jan-1980 Jan-1990 Jan-2000 Jan-2010 Recession Note: The real federal funds effective rate is calculated by subtracting the core PCE inflation rate from the nominal federal funds effective rate. A core PCE inflation rate of 1.8% is assumed for March. Source: Federal Reserve Board, BEA, NBER, Haver Analytics 13
Figure 9: Real Federal Funds Effective Rate: Declines from Peak to Trough January 1960 - March 2017 NBER Peak Decline (Percentage Points) Dates of Decline Federal Funds Rate (%) High Low Apr 1960 2.06 Jan 1960 - Jul 1961 1.96-0.10 Dec 1969 5.81 Aug 1969 - Feb 1971 4.50-1.31 Nov 1973 10.97 Jul 1973 - Mar 1975 6.55-4.42 Jan 1980 8.84 Apr 1980 - Jul 1980 8.74-0.10 Jul 1981 7.74 Jul 1981 - Oct 1986 10.27 2.53 Jul 1990 5.38 May 1989 - Dec 1992 5.50 0.12 Mar 2001 5.81 Jun 2000 - Jun 2004 4.82-0.99 Dec 2007 5.31 Jun 2007 - Jan 2012 3.30-2.01 Note: The real federal funds effective rate is calculated by subtracting the core PCE inflation rate from the nominal federal funds effective rate. A core PCE inflation rate of 1.8% is assumed for March. Source: Federal Reserve Board, BEA, NBER, Haver Analytics 14
Implications With low short-term interest rates there will be a limited buffer for monetary policy to respond to economic slowdowns Real short-term federal funds rates are likely to be negative more frequently Nominal federal funds rates are likely to reach zero more frequently It is likely to be common for central banks to engage in asset purchases to stimulate the economy by reducing longer-term rates 15
Figure 10: Inflation Rate: Change in Personal Consumption Expenditures (PCE) Price Index January 1960 - February 2017 12 Percent Change from Year Earlier 9 6 3 2% Inflation Target 0-3 Jan-1960 Jan-1970 Jan-1980 Jan-1990 Jan-2000 Jan-2010 Recession Source: BEA, NBER, Haver Analytics 16
Figure 11: Productivity Growth: Change in Real Output Per Hour, Nonfarm Business Sector, All Persons, 40-Quarter Moving Average 1960:Q1-2016:Q4 4 Quarterly Percent Change at Annual Rate 3 2 1 0 1960:Q1 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Recession Source: BLS, NBER, Haver Analytics 17
Figure 12: Civilian Labor Force Growth 1960:Q1-2017:Q1 4 3 Percent Change from Year Earlier Civilian Labor Force Growth Linear Trend Line 2 1 0-1 1960:Q1 1970:Q1 1980:Q1 1990:Q1 2000:Q1 2010:Q1 Recession Source: BLS, NBER, Haver Analytics 18
Implications (Continued) There may be a trade-off with a low inflation target that policymakers may be willing to make, depending on their willingness to manipulate the balance sheet Many developed countries are experiencing low inflation rates and demographic trends that have resulted in lower short-term interest rates Balance-sheet tools are likely to be a more common and necessary feature of monetary policy in combating future recessions in many economies around the world 19
Concluding Observations I see it as quite likely that use of the central bank balance sheet will be necessary in future economic downturns In my view, starting to shrink the balance sheet earlier and doing so in a very gradual fashion implies very little reduction in the degree of monetary stimulus coming from the U.S. central bank s balance sheet Policymakers can then focus on gradual increases in the federal funds rate target as the primary mechanism for normalizing monetary policy and calibrating the economy 20