Part 3: Monetary Policy: Recent Developments and Outlook

Monetary Policy over the Second Half of 2009 and Early 2010

In order to provide monetary stimulus to support a sustainable economic expansion, the Federal Open Market Committee (FOMC) maintained a target range for the federal funds rate of 0 to 1/4 percent throughout 2009 and into early 2010 (figure 56). The Federal Reserve also continued its program of large-scale asset purchases, completing purchases of $300 billion in Treasury securities and making considerable progress toward completing its announced purchases of $1.25 trillion of agency mortgage-backed securities (MBS) and about $175 billion of agency debt.

However, with financial market conditions improving, the Federal Reserve took steps to begin winding down many of its special credit and liquidity programs in 2009. On June 25, the Federal Reserve announced that it was extending the authorizations of several of these programs from October 30, 2009, to February 1, 2010. However, the terms of some of these facilities were tightened somewhat, the amounts to be offered under the Term Auction Facility (TAF) were reduced, and the authorization for the Money Market Investor Funding Facility was not extended.¹⁸ Over the summer, the Federal Reserve continued to trim the amounts offered through the TAF.

The information reviewed at the August 11-12 FOMC meeting suggested that overall economic activity was stabilizing after having contracted during 2008 and early 2009. Nonetheless, meeting participants generally saw the economy as likely to recover only slowly during the second half of 2009 and as still vulnerable to adverse shocks. Although housing activity apparently was beginning to turn up, the weak labor market continued to restrain household income, and earlier declines in net worth were still holding back spending. Developments in financial markets leading up to the meeting were broadly positive, and the cumulative improvement in market functioning since the spring was significant. However, the pickup in financial markets was seen as due, in part, to support from various government programs. Moreover, credit remained tight, with many banks reporting that they continued to tighten loan standards and terms. Overall prices for personal consumption expenditures (PCE) rose in June after changing little in each of the previous three months. Excluding food and energy, PCE prices moved up moderately in June.

Given the prospects for an initially modest economic recovery, substantial resource slack, and subdued inflation, the Committee agreed at its August meeting that it should maintain its target range for the federal funds rate at 0 to 1/4 percent. FOMC participants expected only a gradual upturn in economic activity and subdued inflation and thought it most likely that the federal funds rate would need to be maintained at an exceptionally low level for an extended period. With the downside risks to the economic outlook now considerably reduced but the economic recovery likely to be subdued, the Committee also agreed that neither expansion nor contraction of its program of asset purchases was warranted at the time. The Committee did, however, decide to gradually slow the pace of the remainder of its purchases of $300 billion of Treasury securities and extend their completion to the end of October to help promote a smooth transition in financial markets. Policymakers noted that, with the programs for purchases of agency debt and MBS not due to expire until the end of the year, they did not need to make decisions at the meeting about any potential modifications to those programs.

By the time of the September 22–23 FOMC meeting, incoming data suggested that overall economic activity was beginning to pick up. Factory output, particularly motor vehicle production, rose in July and August. Consumer spending on motor vehicles during that period was boosted by government rebates and greater dealer incentives. Household spending outside of motor vehicles appeared to rise in August after having been roughly flat from May through July. Sales data for July indicated further increases in the demand for both new and existing single-family homes. Although employment continued to contract in August, the pace of job losses had slowed noticeably from earlier in the year. Developments in financial markets were again regarded as broadly positive; meeting participants saw the cumulative improvement in market functioning and pricing since the spring as substantial. Despite these positive factors, participants still viewed the economic recovery as likely to be quite restrained. Credit from banks remained difficult to obtain and costly for many borrowers; these conditions were expected to improve only gradually. Many regional and small banks were vulnerable to the deteriorating performance of commercial real estate loans. In light of recent experience, consumers were likely to be cautious in spending, and business contacts indicated that their firms would also be cautious in hiring and investing even as demand for their products picked up. Some of the recent gains in economic activity probably reflected support from government policies, and participants expressed considerable uncertainty about the likely strength of the upturn once those supports were withdrawn or their effects waned. Core consumer price inflation remained subdued, while overall consumer price inflation increased in August, boosted by a sharp upturn in energy prices.

Although the economic outlook had improved further and the risks to the forecast had become more balanced, the recovery in economic activity was likely to be protracted. With substantial resource slack likely to persist and longer-term inflation expectations stable, the Committee anticipated that inflation would remain subdued for some time. Under these circumstances, the Committee judged that the costs of the economic recovery turning out to be weaker than anticipated could be relatively high. Accordingly, the Committee agreed to maintain its target range for the federal funds rate at 0 to 1/4 percent and to reiterate its view that economic conditions were likely to warrant an exceptionally low level of the federal funds rate for an extended period. With respect to the large-scale asset purchase programs, the Committee indicated its intention to purchase the full $1.25 trillion of agency MBS that it had previously established as the maximum for this program. With respect to agency debt, the Committee agreed to reiterate its intention to purchase up to $200 billion of these securities. To promote a smooth transition in markets as these programs concluded, the Committee decided to gradually slow the pace of both its agency MBS and agency debt purchases and to extend their completion through the end of the first quarter of 2010. To keep inflation expectations well anchored, policymakers agreed on the importance of the Federal Reserve continuing to communicate that it has the tools and willingness to begin withdrawing monetary policy accommodation at the appropriate time and pace to prevent any persistent increase in inflation.

On September 24, the Board of Governors announced a gradual reduction in amounts to be auctioned under the TAF through January and indicated that auctions of credit with maturities longer than 28 days would be phased out by the end of 2009. Usage of the TAF had been declining in recent months as financial market conditions had continued to improve. The Money Market Investor Funding Facility, which had been established in October 2008 to help arrest a run on money market mutual funds, expired as scheduled on October 30, 2009.

At the November 3–4 FOMC meeting, participants agreed that the incoming information suggested that economic activity was picking up as anticipated, with output continuing to expand in the fourth quarter. Business inventories were being brought into better alignment with sales, and the pace of inventory runoff was slowing. The gradual recovery in construction of single-family homes from its extremely low level earlier in the year appeared to be continuing. Consumer spending appeared to be rising even apart from the effects of fiscal incentives to purchase autos. Financial market developments over recent months were generally regarded as supportive of continued economic recovery. Further, the outlook for growth abroad had improved since earlier in the year, especially in Asia, auguring well for U.S. exports. Meanwhile, consumer price inflation remained subdued. In spite of these largely positive developments, participants at the November meeting noted that they were unsure how much of the recent firming in final demand reflected the effects of temporary fiscal programs. Downside risks to economic activity included continued weakness in the labor market and its implications for the growth of household income and consumer confidence. Bank credit remained tight. Nonetheless, policymakers expected the recovery to continue in subsequent quarters, although at a pace that would be rather slow relative to historical experience after severe downturns. FOMC participants noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations. The Committee agreed that it was important to remain alert to these risks.

Based on this outlook, the Committee decided to maintain the target range for the federal funds rate at 0 to 1/4 percent and noted that economic conditions, including low levels of resource utilization, subdued inflation trends, and stable inflation expectations, were likely to warrant exceptionally low rates for an extended period. With respect to the large-scale asset purchase programs, the Committee reiterated its intention to purchase $1.25 trillion of agency MBS by the end of the first quarter of 2010. Because of the limited availability of agency debt and concerns that larger purchases could impair market functioning, the Committee also agreed to specify that its agency debt purchases would cumulate to about $175 billion by the end of the first quarter, $25 billion less than the previously announced maximum for these purchases. The Committee also decided to reiterate its intention to gradually slow the pace of purchases of agency MBS and agency debt to promote a smooth transition in markets as the announced purchases are completed.

On November 17, the Board of Governors announced that, in light of continued improvement in financial market conditions, in January 2010 the maximum maturity of primary credit loans at the discount window for depository institutions would be reduced to 28 days from 90 days.

The information reviewed at the December 15–16 FOMC meeting suggested that the recovery in economic activity was gaining momentum. Although the unemployment rate remained very elevated and capacity utilization low, the pace of job losses had slowed noticeably since the summer, and industrial production had sustained the broad-based expansion that began in the third quarter. Consumer spending expanded solidly in October. Sales of new homes had risen in October after two months of little change, while sales of existing homes continued to increase strongly. Financial market conditions were generally regarded as having become more supportive of continued economic recovery during the intermeeting period. A jump in energy prices pushed up headline inflation somewhat, but core consumer price inflation remained subdued. Although some of the recent data had been better than anticipated, policymakers generally saw the incoming information as broadly in line with their expectations for a moderate economic recovery and subdued inflation. Consistent with experience following previous financial crises here and abroad, FOMC participants broadly anticipated that the pickup in output and employment would be rather slow relative to past recoveries from deep recessions.

The Committee made no changes to either its large-scale asset purchase programs or its target range for the federal funds rate of 0 to 1/4 percent and, based on the outlook for a relatively sluggish economic recovery, decided to reiterate its anticipation that economic conditions, including low levels of resource utilization, subdued inflation trends, and stable inflation expectations, were likely to warrant exceptionally low rates for an extended period. Committee members and Board members agreed that substantial improvements in the functioning of financial markets had occurred; accordingly, they agreed that the statement to be released following the meeting should note the anticipated expiration of most of the Federal Reserve's special liquidity facilities on February 1, 2010.

At the January 26–27 meeting, the Committee agreed that the incoming information, though mixed, indicated that overall economic activity had strengthened in recent months, about as expected. Consumer spending was well maintained in the fourth quarter, and business expenditures on equipment and software appeared to expand substantially. However, the improvement in the housing market slowed, and spending on nonresidential structures continued to fall. Recent data suggested that the pace of inventory liquidation diminished considerably last quarter, providing a sizable boost to economic activity. Indeed, industrial production advanced at a solid rate in the fourth quarter. In the labor market, layoffs subsided noticeably in the final months of last year, but the unemployment rate remained elevated and hiring stayed quite limited. The weakness in labor markets continued to be an important concern for the Committee; moreover, the prospects for job growth remained a significant source of uncertainty in the economic outlook, particularly in the outlook for consumer spending. Financial market conditions were supportive of economic growth. However, net debt financing by nonfinancial businesses was near zero in the fourth quarter after declining in the third, consistent with sluggish demand for credit and tight credit standards and terms at banks. Increases in energy prices pushed up headline consumer price inflation even as core consumer price inflation remained subdued.

In their discussion of monetary policy for the period ahead, the Committee agreed that neither the economic outlook nor financial conditions had changed appreciably since the December meeting and that no changes to the Committee's large-scale asset purchase programs or to its target range for the federal funds rate of 0 to 1/4 percent were warranted at this meeting. Further, policymakers reiterated their anticipation that economic conditions, including low levels of resource utilization, subdued inflation trends, and stable inflation expectations, were likely to warrant exceptionally low rates for an extended period. The Committee affirmed its intention to purchase a total of $1.25 trillion of agency MBS and about $175 billion of agency debt by the end of the current quarter and to gradually slow the pace of these purchases to promote a smooth transition in markets. Committee members and Board members agreed that with substantial improvements in most financial markets, including interbank markets, the statement would indicate that on February 1, 2010, the Federal Reserve was closing several special liquidity facilities and that the temporary swap lines with foreign central banks would expire. In addition, the statement would say that the Federal Reserve was in the process of winding down the TAF and that the final auction would take place in March 2010.

On February 1, 2010, given the overall improvement in funding markets, the Federal Reserve allowed the Primary Dealer Credit Facility, the Term Securities Lending Facility, the Commercial Paper Funding Facility, and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility to expire. The temporary swap lines with foreign central banks were closed on the same day. On February 18, 2010, the Federal Reserve announced a further normalization of the terms of loans made under the primary credit facility: The rate charged on these loans was increased from 1/2 percent to 3/4 percent, effective on February 19, and the typical maximum maturity for such loans was shortened to overnight, effective on March 18, 2010. On the same day, the Federal Reserve also announced that the minimum bid rate on the final TAF auction on March 8 had been raised to 50 basis points, 1/4 percentage point higher than in previous auctions. The Federal Reserve noted that the modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.

Over the course of 2009, the Federal Reserve continued to undertake initiatives to improve communications about its policy actions. These initiatives are described in detail in the box "Federal Reserve Initiatives to Increase Transparency."

Monetary Policy as the Economy Recovers

The actions taken by the Federal Reserve to support financial market functioning and provide extraordinary monetary stimulus to the economy have led to a rapid expansion of the Federal Reserve's balance sheet, from less than $900 billion before the crisis began in 2007 to about $2.3 trillion currently. The expansion of the Federal Reserve's balance sheet has been accompanied by a comparable increase in the quantity of reserve balances held by depository institutions. Bank reserves are currently far above their levels prior to the crisis. Even though, as noted in recent statements of the FOMC, economic conditions are likely to warrant exceptionally low rates for an extended period, in due course, as the expansion matures, the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflation pressures. That tightening will be accomplished partly through changes that will affect the composition and size of the Federal Reserve's balance sheet. Eventually, the level of reserves and the size of the Federal Reserve's balance sheet will be reduced substantially.

The Federal Reserve has a number of tools that will enable it to firm the stance of policy at the appropriate time and to the appropriate degree, some of which do not affect the size of the balance sheet or the quantity of reserves. Most importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on banks' holdings of reserve balances at Federal Reserve Banks. By increasing the interest rate paid on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, because banks will not supply short-term funds to the money markets at rates significantly below what they can earn by simply leaving funds on deposit at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected, in turn, in longer-term interest rates and in financial conditions more generally through standard transmission mechanisms, thus preventing inflationary pressures from developing.

The Federal Reserve has also been developing a number of additional tools that will reduce the quantity of reserves held by the banking system and lead to a tighter relationship between the interest rate that the Federal Reserve pays on banks' holdings of reserve balances and other short-term interest rates. Reverse repurchase agreements (reverse repos) are one such tool; in a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase it at some specified date in the future. The counterparty's payment to the Federal Reserve has the effect of draining an equal quantity of reserves from the banking system. Recently, by developing the capacity to conduct such transactions in the triparty repo market, the Federal Reserve has enhanced its ability to use reverse repos to absorb very large quantities of reserves. The capability to carry out these transactions with primary dealers, using the Federal Reserve's holdings of Treasury and agency debt securities, has already been tested and is currently available if and when needed. To further increase its capacity to drain reserves through reverse repos, the Federal Reserve is also in the process of expanding the set of counterparties with which it can transact and is developing the infrastructure necessary to use its MBS holdings as collateral in these transactions.

As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Federal Reserve would likely offer large blocks of such deposits through an auction mechanism. The effect of these transactions would be to convert a portion of depository institutions' holdings of reserve balances into deposits that could not be used to meet depository institutions' very short-term liquidity needs and could not be counted as reserves. The Federal Reserve published in the Federal Register a proposal for such a term deposit facility and is in the process of reviewing the public comments received. After a revised proposal is approved by the Board, the Federal Reserve expects to be able to conduct test transactions in the spring and to have the facility available if necessary shortly thereafter. Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly should it choose to do so.

The Federal Reserve also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve's balance sheet. It would likely also put at least some direct upward pressure on longer-term yields.

The Treasury's temporary Supplementary Financing Program (SFP)--through which the Treasury issues Treasury bills to the public and places the proceeds in a special deposit account at the Federal Reserve--could also be used to drain reserves and support the Federal Reserve's control of short-term interest rates. However, the use of the SFP must be compatible with the Treasury's debt-management objectives. The SFP is not a necessary element in the Federal Reserve's set of tools to achieve an appropriate monetary policy stance in the future; still, any amount outstanding under the SFP will result in a corresponding decrease in the quantity of reserves in the banking system, which could be helpful in the Federal Reserve's conduct of policy.

The exact sequence of steps and combination of tools that the Federal Reserve chooses to employ as it exits from its current very accommodative policy stance will depend on economic and financial developments. One possible trajectory would be for the Federal Reserve to continue to test its tools for draining reserves on a limited basis in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more-significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate on reserves at about the same time it commences draining operations.

The Federal Reserve currently does not anticipate that it will sell any of its securities holding in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery. However, to help reduce the size of its balance sheet and the quantity of reserves, the Federal Reserve is allowing agency debt and MBS to run off as they mature or are prepaid. The Federal Reserve is rolling over all maturing Treasury securities, but in the future it might decide not to do so in all cases. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its securities holdings will be Treasury securities. Although passively redeeming agency debt and MBS as they mature or are prepaid will move the Federal Reserve in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be gradual, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.

As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate. In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue, and any deliberation will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn. The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.

Footnotes

18. In particular, the Federal Reserve began requiring money market mutual funds to have experienced redemptions exceeding a certain threshold before becoming eligible to borrow from the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. The Federal Reserve also suspended auctions conducted under the Term Securities Lending Facility (TSLF) involving only Schedule 1 collateral and reduced the frequency of TSLF auctions involving Schedule 2 collateral. Schedule 1 collateral refers to securities eligible for the open market operations arranged by the Federal Reserve's Open Market Trading Desk--generally Treasury securities, agency debt, or agency MBS. Schedule 2 collateral includes all Schedule 1 collateral as well as investment-grade corporate, municipal, mortgage-backed, and asset-backed securities. Return to text