Part 3: Monetary Policy: Recent Developments and OutlookMonetary Policy Report submitted to the Congress on July 21, 2009, pursuant to section 2B of the Federal Reserve Act
Monetary Policy over the First Half of 2009
Over the second half of 2008, the Federal Open Market Committee (FOMC) eased the stance of monetary policy by decreasing its target for the federal funds rate from 2 percent to a range between 0 and 1/4 percent and took a number of additional actions to increase liquidity and improve the functioning of financial markets (figure 55). During the first half of 2009, the FOMC maintained its target range for the federal funds rate of 0 to 1/4 percent, and it extended and modified the nontraditional policy actions taken previously.
The data reviewed at the January 27-28 FOMC meeting indicated a continued sharp contraction in economic activity. The housing market remained on a steep downward trajectory, consumer spending continued its significant decline, the slowdown in business equipment investment intensified, and foreign demand had weakened. Conditions in the labor market had continued to deteriorate rapidly, and the drop in industrial production had accelerated. Headline consumer prices fell in November and December, reflecting declines in consumer energy prices; core consumer prices were about flat in those months. Although credit conditions generally had remained tight, some financial markets--particularly those that were receiving support from Federal Reserve liquidity facilities and other government actions--exhibited modest signs of improvement. Meeting participants--Federal Reserve Board governors and Federal Reserve Bank presidents--anticipated that a gradual recovery in U.S. economic activity would begin in the second half of the year in response to monetary easing, additional fiscal stimulus, relatively low energy prices, and continued efforts by the government to stabilize the financial sector and increase the availability of credit. Committee members agreed that keeping the target range for the federal funds rate at 0 to 1/4 percent would be appropriate. In its January statement, the FOMC reiterated that the Federal Reserve would use all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The Committee also stated that, in addition to the purchases of agency debt and mortgage-backed securities (MBS) already under way, it was prepared to purchase longer-term Treasury securities if evolving circumstances indicated that such transactions would be particularly effective in improving conditions in private credit markets. The Committee indicated that it would continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments. It would also continue to assess whether expansions of, or modifications to, lending facilities would serve to further support credit markets and economic activity and help preserve price stability.
On February 7, 2009, the Committee met by conference call in a joint session with the Board of Governors to discuss the potential role of the Federal Reserve in the Treasury's forthcoming Financial Stability Plan. The Federal Reserve's primary direct role in the plan would be through an expansion of the previously announced Term Asset-Backed Securities Loan Facility (TALF), which would be supported by additional funds from the Treasury's Troubled Asset Relief Program (TARP). It was anticipated that such an expansion would provide additional assistance to financial markets and institutions in meeting the credit needs of households and businesses and thus would support overall economic activity.
At the March FOMC meeting, nearly all participants indicated that economic conditions had deteriorated relative to their expectations at the time of the January meeting. Economic activity continued to fall sharply, with widespread declines in payroll employment and industrial production. Consumer spending had remained flat at a low level, the housing market weakened further, and nonresidential construction fell. Business spending on equipment and software had continued to decline across a broad range of categories. Despite the cutbacks in production, inventory overhangs appeared to have worsened in a number of areas. Of particular note was the sharp fall in foreign economic activity, which was having a negative effect on U.S. exports. Both headline and core consumer prices had edged up in January and February. Credit conditions remained very tight, and financial markets continued to be fragile and unsettled, with pressures on financial institutions generally having intensified over the past few months. Overall, participants expressed concern about downside risks to an outlook for activity that was already weak. Nonetheless, looking beyond the very near term, participants saw a number of market forces and policies then in place as eventually leading to economic recovery. Notably, the low level of mortgage interest rates, reduced house prices, and the Administration's new programs to encourage mortgage refinancing and mitigate foreclosures ultimately could bring about a lower cost of homeownership, a sustained increase in home sales, and a stabilization of house prices.
In light of the deterioration in the economic situation and outlook, Committee members agreed that substantial additional purchases of longer-term assets would be appropriate. In its March statement, the Committee announced that, to provide greater support to mortgage lending and housing markets, it would increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency MBS, bringing its total purchases of these securities up to $1.25 trillion in 2009, and that it would increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Committee decided to maintain the target range for the federal funds rate at 0 to 1/4 percent and noted in its March statement that it anticipated that economic conditions were likely to warrant exceptionally low levels of the federal funds rate for an extended period. The Committee also noted that the Federal Reserve had launched the TALF to facilitate the extension of credit to households and small businesses, and it anticipated that the range of eligible collateral for this facility was likely to be expanded to include other financial assets. The Committee stated that it would continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.
On March 23, the Federal Reserve and the Treasury issued a joint statement on the role of the Federal Reserve in preserving financial and monetary stability. In the statement, the Federal Reserve and the Treasury agreed to continue to cooperate on measures to improve the stability and functioning of the financial system while minimizing the associated credit risk to the Federal Reserve and preserving the ability of the Federal Reserve to achieve its monetary policy objectives. The two government entities also agreed to work together with the Congress on a comprehensive resolution regime for systemically important financial institutions, and the Treasury promised to remove the emergency loans for systemically important institutions from the Federal Reserve's balance sheet over time to the extent its authorities permit.
At the FOMC meeting on April 28 and 29, participants noted that the pace of decline in some components of final demand appeared to have slowed. Consumer spending firmed in the first quarter after dropping markedly during the second half of 2008. Housing activity remained depressed but seemed to have leveled off in February and March. In contrast, businesses had cut production and employment substantially in recent months--reflecting, in part, inventory overhangs that had persisted into the early part of the year--and fixed investment continued to contract. Headline and core consumer prices rose at a moderate pace over the first three months of the year. Participants noted that financial market conditions had generally strengthened, and surveys and anecdotal reports pointed to a pickup in household and business confidence, which nonetheless remained at very low levels. Yields on Treasury and agency securities had fallen after the release of the March FOMC statement, which noted the increase in planned purchases of longer-term securities. However, this initial drop was subsequently reversed amid the improved economic outlook, an easing of concerns about financial institutions, and perhaps some unwinding of flight-to-quality flows. Participants anticipated that the acceleration in final demand and economic activity over the next few quarters would be modest, with growth of consumption expenditures likely to be restrained and business investment spending probably shrinking further. Looking further ahead, participants considered a number of factors that would be likely to restrain the pace of economic recovery over the medium term. Strains in credit markets were expected to recede only gradually as financial institutions continued to rebuild their capital and remained cautious in their approach to asset-liability management, especially given that the outlook for credit performance would probably remain weak. Households would likely continue to be cautious, and their desired saving rates would be relatively high over the extended period that would be required to bring their wealth back up to more normal levels relative to income. The stimulus from fiscal policy was expected to diminish over time as the government budget moved to a sustainable path. Demand for U.S. exports would also take time to revive, reflecting the gradual recovery of economic activity in our major trading partners.
Against this backdrop, the FOMC indicated that it would maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipated that economic conditions would be likely to warrant exceptionally low levels of the federal funds rate for an extended period. The Committee reiterated that, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve would purchase a total of up to $1.25 trillion of agency MBS and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve would buy up to $300 billion of Treasury securities by autumn. The Committee would continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve was facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs. The Committee indicated that it would continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.
The information reviewed at the June 23-24 FOMC meeting suggested that the economy remained weak, though declines in activity seemed to be lessening. Consumer spending appeared to have stabilized, sales and starts of new homes flattened out, and the recent declines in capital spending did not look as severe as those that had occurred around the turn of the year. At the same time, labor markets and industrial production continued to deteriorate sharply. Apart from a tax-induced jump in tobacco prices, consumer price inflation was fairly quiescent in recent months, although an upturn in energy prices appeared likely to boost headline inflation in June. Conditions and sentiment in financial markets had continued to show signs of improvement since the last meeting. The results of the Supervisory Capital Assessment Program (SCAP) were positively received by financial markets, credit default swap spreads of banking organizations declined considerably, and the institutions involved in the SCAP were subsequently able to issue significant amounts of public equity and nonguaranteed debt. The functioning of short-term funding markets improved, broad stock price indexes increased, and spreads on corporate bonds continued to narrow. Nominal Treasury yields climbed steeply, reflecting investors' perceptions of an improved economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings.
In its June statement, the FOMC reiterated that it would employ all available tools to promote economic recovery and preserve price stability. It noted that it would maintain its target range for the federal funds rate at 0 to 1/4 percent and continued to anticipate that economic conditions would likely warrant exceptionally low levels of the federal funds rate for an extended period. The FOMC indicated that, as it had previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve would purchase a total of up to $1.25 trillion of agency MBS and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve would buy up to $300 billion of Treasury securities by autumn. The Committee noted that it would continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The FOMC also stated that the Federal Reserve was monitoring the size and composition of its balance sheet and would make adjustments to its credit and liquidity programs as warranted.
Conditions in financial markets had improved notably by the end of June, although market functioning in many areas remained impaired and seemed likely to remain strained for some time. Usage of some of the Federal Reserve's liquidity programs had also decreased in recent months. Against this backdrop, on June 25, the Federal Reserve announced extensions of and modifications to a number of its liquidity programs (see table 2 for a summary of the changes).14 The Federal Reserve noted that the Board and the FOMC would continue to monitor closely the condition of financial markets and the need for and effectiveness of the Federal Reserve's special liquidity facilities and arrangements. Should the recent improvements in market conditions continue, the Board and the FOMC anticipated that a number of the facilities might not need to be extended beyond February 1, 2010. However, if financial stresses did not moderate as expected, the Board and the FOMC were prepared to extend the terms of some or all of the facilities as needed to promote financial stability and economic growth. The public would receive timely notice of planned extensions, discontinuations, or modifications of Federal Reserve programs. The next section of this report, "Monetary Policy as the Economy Recovers," has further discussion related to the evolution of these programs.
|Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)||Extended to February 1, 2010||Money market mutual funds have to experience material outflows before being able to sell asset-backed commercial paper that would be eligible collateral for AMLF loans.|
|Central bank swap lines||Extended to February 1, 2010||…|
|Commercial Paper Funding Facility||Extended to February 1, 2010||…|
|Money Market Investor Funding Facility||Expiration date remains at October 30, 2009||…|
|Primary Dealer Credit Facility||Extended to February 1, 2010||…|
|Term Asset-Backed Securities Loan Facility||Expiration date remains at December 31, 2009||…|
|Term Auction Facility||No fixed expiration date||Auction amounts reduced initially to $125 billion.|
|Term Securities Lending Facility||Extended to February 1, 2010||Auctions backed by Schedule 1 collateral suspended effective July 1, 2009. Auctions backed by Schedule 2 collateral now conducted every four weeks. Total amount offered reduced initially to $75 billion.|
… Not applicable.
SOURCE: Federal Reserve Board.
Over the first half of the year, the Federal Reserve also undertook a number of initiatives to improve communications about its policy actions. These initiatives are described more fully in the box titled "Federal Reserve Initiatives to Increase Transparency."
Federal Reserve Initiatives to Increase Transparency
The Federal Reserve took a number of nontraditional policy actions during the current episode of financial turmoil. In late 2008, Chairman Bernanke asked Vice Chairman Kohn to lead a review of how Federal Reserve disclosure policies should be adapted to make more information about these programs available to the public and to the Congress. A guiding principle of the review was that the Federal Reserve would seek to provide to the public as much information and analysis as possible, consistent with its objectives of promoting maximum employment and price stability. The Federal Reserve subsequently created a separate section of its website devoted to providing data, explanations, and analyses of its lending programs and balance sheet.1 Postings in the first half of 2009 included additional explanatory material and details about a number of Federal Reserve credit and liquidity programs, the annual financial statements of the 12 Federal Reserve Banks, the Board of Governors, and the limited liability companies (LLCs) created in 2008 to avert the disorderly failures of The Bear Stearns Companies, Inc., and American International Group, Inc., as well as the most recent reports to the Congress on the Federal Reserve's emergency lending programs.
On June 10, the Federal Reserve issued the first of a series of monthly reports to provide more information on its credit and liquidity programs.2 For many of those programs, the new information provided in the report includes the number of borrowers and the amounts borrowed by type of institution, collateral by type and credit rating, and data on the concentration of borrowing. The report also includes information on liquidity swap usage by country, quarterly income earned on different classes of Federal Reserve assets, and asset distribution and other information on the LLCs. In addition, the report summarizes and discusses recent developments across a number of Federal Reserve programs. In addition to the new report, the Federal Reserve Bank of New York recently made available the investment management agreements related to its financial stability and liquidity activities.3
2. See Board of Governors of the Federal Reserve System (2009), Federal Reserve System Monthly Report on Credit and Liquidity Programs and the Balance Sheet (1.36 MB PDF) (Washington: Board of Governors, July). Return to text
Monetary Policy as the Economy Recovers
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve's legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.
Monetary policy actions taken over the past year have led to a considerable increase in the assets held by the Federal Reserve. This increase in assets reflects both the expansion of Federal Reserve liquidity facilities and the purchases of longer-term securities. On the margin, the extension of credit and acquisition of assets by the Federal Reserve has been funded by crediting the reserve accounts of depository institutions (henceforth referred to as banks). Thus, the increase in Federal Reserve assets has been associated with substantial growth in banks' reserve balances, leaving the level of reserves far above that typically observed when short-term interest rates were significantly greater than zero.
To some extent, a contraction in the stock of reserve balances will occur automatically as financial conditions improve. In particular, most of the liquidity facilities deployed by the Federal Reserve in the current period of financial turmoil are priced at a premium over normal interest rate spreads or have a minimum bid rate that is high enough to make them unattractive under normal market conditions. Thus, the sizes of these programs, as well as the stock of reserve balances they create, will tend to diminish automatically as financial strains abate. Indeed, as noted elsewhere in this report, total credit extended to banks and other market participants (excluding support of critical institutions) declined from about $1.5 trillion as of December 31, 2008, to less than $600 billion as of July 15, 2009, as financial conditions improved. In addition, redemptions of the Federal Reserve's holdings of agency debt, agency MBS, and longer-term Treasury securities are expected to occur at a rate of $100 billion to $200 billion per year over the next few years, leading to further reductions in reserve balances.
But even after lending facilities have wound down and holdings of long-term assets have begun to run off, the volume of assets on the Federal Reserve's balance sheet may remain very large for some time. Without additional actions, the level of bank reserves would continue to remain elevated as well.
Despite continued large holdings of assets, the Federal Reserve will have at its disposal two broad means of tightening monetary policy at the appropriate time. In principle, either of these methods would suffice to raise short-term interest rates; however, to ensure effectiveness, the two methods will most likely be used in combination.
The first method for tightening monetary policy relies on the authority that the Congress granted to the Federal Reserve last fall to pay interest on the balances maintained by banks. By raising the rate it pays on banks' reserve balances, the Federal Reserve will be able to tighten monetary policy by inducing increases in the federal funds rate and other short-term market interest rates. In general, banks will not supply funds to the money market at an interest rate lower than the rate they can earn risk free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in the market at rates below the rate of interest paid by the Federal Reserve, as such borrowing allows them to earn a spread without any risk. Thus, raising the interest rate paid on balances that banks hold at the Federal Reserve should provide a powerful upward influence on short-term market interest rates, including the federal funds rate, without the need to drain reserve balances. A number of foreign central banks have been able to maintain overnight interbank interest rates at or above the level of interest paid on bank reserves even in the presence of unusually high levels of reserve balances (see the box titled "Foreign Experience with Interest on Reserves").
Despite this logic, the federal funds rate has been somewhat lower than the rate of interest banks earn on reserve balances; the gap was especially noticeable in October and November 2008, when payment of interest on reserves first began. This gap appears to have reflected several factors: First, the Federal Reserve is not allowed to pay interest on balances held by nondepository institutions, including some large lenders in the federal funds market such as the government-sponsored enterprises (GSEs). Such institutions may have an incentive to lend at rates below the rate that banks receive on reserve balances. Second, the payment of interest on reserves was a new policy at the time that the gap was particularly noticeable, and banks may not have had time to adjust their operations to the new regime. Third, the unusually strained conditions in financial markets at that time may have reduced the willingness of banks to arbitrage by borrowing in the federal funds market at rates below the rate paid on reserve balances and earning a higher rate by increasing their deposits at the Federal Reserve. The latter two factors are not likely to persist, particularly as the economy and financial markets recover. Moreover, if, as the economy recovers, large-scale lending in the federal funds market by nondepository institutions threatens to hold the federal funds rate below its target, the Federal Reserve has various options to deal with the problem. For example, it could offer these institutions the option of investing in reverse repurchase agreements. Under these transactions, the Federal Reserve sells securities from its portfolio, thereby removing funds from the market, and agrees to buy back the securities at a later date.15 Eliminating the incentive of nondepository institutions to lend their excess funds into short-term money markets would help ensure that raising the rate of interest paid on reserves would raise the federal funds rate and tighten monetary conditions even if the level of reserve balances were to remain high.
The second method for tightening monetary policy, despite a high level of assets on the Federal Reserve's balance sheet, is to take steps to reduce the overall level of reserve balances. Policymakers have several options for reducing the level of reserve balances should such action be desired. First, the Federal Reserve could engage in large-scale reverse repurchase agreements with financial market participants, including GSEs as well as other institutions. Reverse repurchase agreements are a traditional tool of Federal Reserve monetary policy implementation. Second, the Treasury could sell more bills and deposit the proceeds with the Federal Reserve. The Treasury has been conducting such operations since last fall; the resulting deposits are reported on the Federal Reserve balance sheet as the Supplementary Financing Account. One limitation on this option is that the associated Treasury debt is subject to the statutory debt ceiling. Also, to preserve monetary policy independence, the Federal Reserve must ensure that it can achieve its policy objectives without reliance on the Treasury if necessary. A third option is for the Federal Reserve to offer banks the opportunity to hold some of their balances as term deposits. Such deposits would pay interest but would not have the liquidity and transactions features of reserve balances. Term deposits could not be counted toward reserve requirements, nor could they be used to avoid overnight overdraft penalties in reserve accounts.16 Each of these three policy options would allow a tightening of monetary policy by draining reserve balances and raising short-term interest rates. As noted earlier, measures to drain reserves will likely be used in conjunction with increases in the interest rate paid on reserves to tighten conditions in short-term money markets.
Raising the rate of interest on reserve balances and draining reserves through the options just described would allow policy to be tightened even if the level of assets on the Federal Reserve's balance sheet remained very high. In addition, the Federal Reserve retains the option to reduce its stock of assets by selling off a portion of its holdings of longer-term securities before they mature. Asset sales by the Federal Reserve would serve to raise short-term interest rates and tighten monetary policy by reducing the level of reserve balances; in addition, such sales could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets available to investors. In an environment of strengthening economic activity and rising inflation pressures, broad-based increases in interest rates could facilitate the achievement of the Federal Reserve's dual mandate.
In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve's dual objectives of maximum employment and price stability.
Foreign Experience with Interest on Reserves
Paying interest on excess reserve balances, either directly or by allowing banks to place excess balances into an interest-bearing account, is a standard tool used by major foreign central banks. Many have used interest on reserves, in combination with other tools, to maintain a floor under overnight interbank interest rates both in normal circumstances and during the period of financial turmoil. The European Central Bank (ECB), for example, has long allowed banks to place excess reserves into a deposit facility that pays interest at a rate below the ECB's main refinancing rate (its bellwether policy rate). The quantity of funds that banks hold in that facility increased sharply as the ECB expanded its liquidity-providing operations last fall and has remained well above pre-crisis levels; as a result, the euro-area overnight interbank rate fell from a level close to the main refinancing rate toward the rate the ECB pays on deposits--but, importantly, not below that rate. Since November 2008, the Bank of Japan (BOJ) on a temporary basis has paid interest on excess reserve balances, at a rate of 10 basis points per year, which is also its current target for the overnight uncollateralized call rate; the BOJ noted that its action was intended to keep the call rate close to the targeted level as it supplied additional liquidity to the banking system. Indeed, the overnight rate has traded near 10 basis points in recent months, even as reserve balances at the BOJ have risen substantially, returning to their level during much of 2002, when the BOJ was implementing its Quantitative Easing Policy and the call rate was trading at 1 basis point or below. The Bank of Canada and the Bank of England also have used their standing deposit facilities to help manage interbank interest rates.
14. For more details, see Board of Governors of the Federal Reserve System (2009), "Federal Reserve Announces Extensions of and Modifications to a Number of Its Liquidity Programs," press release, June 25. Return to text
15. These transactions are referred to as reverse repurchase agreements to distinguish them from repurchase agreements in which the Federal Reserve is the investor. Return to text
16. To be successful, especially in a period of rising interest rates, such deposits likely would have to pay rates of interest above the overnight rate on reserve balances. To prevent banks from earning risk-free profits by borrowing from the Federal Reserve and investing the proceeds in term deposits, the rate of remuneration on term deposits would have to be kept lower than the rates the Federal Reserve charges on its lending facilities, such as the discount window. Return to text