Part 2: Monetary PolicyMonetary Policy Report submitted to the Congress on February 26, 2013, pursuant to section 2B of the Federal Reserve Act
To promote the objectives given to it by the Congress, the Federal Open Market Committee (FOMC) provided additional monetary accommodation at its September 2012 and December 2012 meetings, by both strengthening its forward guidance regarding the federal funds rate and initiating additional asset purchases.
As discussed in Part 1, incoming economic data throughout the second half of 2012 and into 2013 indicated that economic activity was expanding at a moderate pace. Employment gains were modest, and although the unemployment rate declined somewhat over the period, it remained elevated relative to levels that almost all members of the FOMC viewed as consistent with the Committee's dual mandate. Inflation remained subdued, apart from some temporary variations that largely reflected fluctuations in commodities prices. Members generally attached an unusually high level of uncertainty to their assessments of the economic outlook. Moreover, they continued to judge that the risks to economic growth were tilted to the downside because of strains in financial markets stemming from the sovereign debt and banking situation in Europe, as well as the potential for a significant slowdown in global economic growth and for a sharper-than-anticipated fiscal contraction in the United States. With longer-term inflation expectations stable and still-considerable slack in resource markets, most members anticipated that inflation over the medium term would run at or below the Committee's longer-run goal of 2 percent.
Accordingly, to promote the FOMC's objectives of maximum employment and price stability, the Committee maintained a target range for the federal funds rate of 0 to 1/4 percent throughout the second half of 2012 and provided additional monetary accommodation at its September and December meetings, by both strengthening its forward guidance regarding the federal funds rate and initiating additional purchases of longer-term securities (figure 48). The Committee also completed at year-end the continuation of the program to extend the average maturity of its holdings of Treasury securities that was announced in June 2012 and continued its policy of reinvesting principal payments from its holdings of agency debt and agency-guaranteed mortgage-backed securities (MBS) into agency MBS.
At the September 12-13 meeting, the Committee agreed that the outlook called for additional monetary accommodation, and that such accommodation should be provided by both strengthening its forward guidance regarding the federal funds rate and initiating additional purchases of agency MBS at a pace of $40 billion per month. Along with the ongoing purchases of $45 billion per month of longer-term Treasury securities under the maturity extension program announced in June, these purchases increased the Committee's holdings of longer-term securities by about $85 billion each month through the end of the year. These actions were taken to put downward pressure on longer-term interest rates, support mortgage markets, and help make broader financial conditions more accommodative (see the box "Efficacy and Costs of Large-Scale Asset Purchases"). The Committee agreed that it would closely monitor incoming information on economic and financial developments in coming months, and that if the outlook for the labor market did not improve substantially, it would continue its purchases of agency MBS, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. The Committee also agreed that in determining the size, pace, and composition of its asset purchases, it would, as always, take appropriate account of the likely efficacy and costs of such purchases. This flexible approach was seen as allowing the Committee to tailor its policy over time in response to incoming information while clarifying its intention to improve labor market conditions, thereby enhancing the effectiveness of the action by helping to bolster business and consumer confidence.
The Committee also modified its forward guidance regarding the federal funds rate at the September meeting, noting that exceptionally low levels for the federal funds rate were likely to be warranted at least through mid-2015, longer than had been indicated in previous FOMC statements. Moreover, the Committee stated its expectation that a highly accommodative stance of monetary policy would remain appropriate for a considerable time after the economic recovery strengthens. The new language was meant to clarify that the Committee's anticipation that exceptionally low levels for the federal funds rate were likely to be warranted at least through mid-2015 did not reflect an expectation that the economy would remain weak, but rather reflected the Committee's determination to support a stronger economic recovery.
At the December 11-12 meeting, members judged that continued provision of monetary accommodation was warranted in order to support further progress toward the Committee's goals of maximum employment and price stability. The Committee judged that, following the completion of the maturity extension program at the end of the year, such accommodation should be provided in part by continuing to purchase agency MBS at a pace of $40 billion per month and by purchasing longer-term Treasury securities at a pace initially set at $45 billion per month. The Committee also decided that, starting in January, it would resume rolling over maturing Treasury securities at auction.
With regard to its forward rate guidance, the Committee decided to indicate in the statement that it expects the highly accommodative stance of monetary policy to remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In addition, it replaced the date-based guidance for the federal funds rate with numerical thresholds linked to the unemployment rate and projected inflation. In particular, the Committee indicated that it expected that the exceptionally low range for the federal funds rate would 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 1/2 percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. These thresholds were seen as helping the public to more readily understand how the likely timing of an eventual increase in the federal funds rate would shift in response to unanticipated changes in economic conditions and the outlook. Accordingly, thresholds could increase the probability that market reactions to economic developments would move longer-term interest rates in a manner consistent with the Committee's assessment of the likely future path of short-term interest rates. The Committee indicated in its December statement that it viewed the economic thresholds, at least initially, as consistent with its earlier, date-based guidance. The new language noted that the Committee would also consider other information when determining how long to maintain the highly accommodative stance of monetary policy, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.
At the conclusion of its January 29-30 meeting, the Committee made no changes to its target range for the federal funds rate, its asset purchase program, or its forward guidance for the federal funds rate. The Committee stated that, with appropriate policy accommodation, it expected that economic growth would proceed at a moderate pace and the unemployment rate would gradually decline toward levels the Committee judges consistent with its dual mandate. It noted that strains in global financial markets had eased somewhat, but that it continued to see downside risks to the economic outlook. The Committee continued to anticipate that inflation over the medium term likely would run at or below its 2 percent objective.
Efficacy and Costs of Large-Scale Asset Purchases
In order to provide additional monetary stimulus when short-term interest rates are near zero, the Federal Reserve has undertaken a series of large-scale asset purchase (LSAP) programs. Between late 2008 and early 2010, the Federal Reserve purchased approximately $1.7 trillion in longer-term Treasury securities, agency debt, and agency mortgage-backed securities (MBS). From late 2010 to mid-2011, a second round of LSAPs was implemented, consisting of purchases of $600 billion in longer-term Treasury securities. Between September 2011 and the end of 2012, the Federal Reserve implemented the maturity extension program and its continuation, under which it purchased approximately $700 billion in longer-term Treasury securities and sold or allowed to run off an equal amount of shorter-term Treasury securities. And in September and December 2012, the Federal Reserve announced flow-based purchases of agency MBS and longer-term Treasury securities at initial paces of $40 billion and $45 billion per month, respectively.
These purchases were undertaken in order to put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, thereby supporting the economic recovery. One mechanism through which asset purchases can affect financial conditions is the "portfolio balance channel," which is based on the premise that different financial assets may be reasonably close but imperfect substitutes in investors' portfolios. This assumption implies that changes in the supplies of various assets available to private investors may affect the prices or yields of those assets and the prices of assets that may be reasonably close substitutes. As a result, the Federal Reserve's asset purchases can push up the prices and lower the yields on the securities purchased and influence other asset prices as well. As investors further rebalance their portfolios, overall financial conditions should ease more generally, stimulating economic activity through channels similar to those for conventional monetary policy. In addition, asset purchases could also signal that the central bank intends to pursue a more accommodative policy stance than previously thought, thereby lowering investor expectations about the future path of the federal funds rate and putting additional downward pressure on longer-term yields.
A substantial body of empirical research finds that the Federal Reserve's asset purchase programs have significantly lowered longer-term Treasury yields.1 More important, the effects of LSAPs do not seem to be restricted to Treasury yields. In particular, LSAPs have been found to be associated with significant declines in MBS yields and corporate bond yields as well as with increases in equity prices.
While there seems to be substantial evidence that LSAPs have lowered longer-term yields and eased broader financial conditions, obtaining accurate estimates of the effects of LSAPs on the macroeconomy is inherently difficult, as the counterfactual case--how the economy would have performed without LSAPs--cannot be directly observed. However, econometric models can be used to estimate the effects of LSAPs on the economy under the assumption that the economic effects of the easier financial conditions that are induced by LSAPs are similar to those that are induced by conventional monetary policy easing. Model simulations conducted at the Federal Reserve have generally found that asset purchases provide a significant boost to the economy. For example, a study based on the Federal Reserve Board's FRB/US model estimated that, as of 2012, the first two rounds of LSAPs had raised real gross domestic product almost 3 percent and increased private payroll employment by about 3 million jobs, while lowering the unemployment rate about 1.5 percentage points, relative to what would have been expected otherwise. These simulations also suggest that the program materially reduced the risk of deflation.2
Of course, all model-based estimates of the macroeconomic effects of LSAPs are subject to considerable statistical and modeling uncertainty and thus should be treated with caution. Indeed, while some other studies also report significant macroeconomic effects from asset purchases, other research finds smaller effects.3 Nonetheless, a balanced reading of the evidence supports the conclusion that LSAPs have provided meaningful support to the economic recovery while mitigating deflationary risks.
The potential benefits of LSAPs must be considered alongside their possible costs. One potential cost of conducting additional LSAPs is that the operations could lead to a deterioration in market functioning or liquidity in markets where the Federal Reserve is engaged in purchasing. More specifically, if the Federal Reserve becomes too dominant a buyer in a certain market, trading among private participants could decrease enough that market liquidity and price discovery become impaired. As the global financial system relies on deep and liquid markets for U.S. Treasury securities, significant impairment of this market would be especially costly; impairment of this market could also impede the transmission of monetary policy. Although the large volume of the Federal Reserve's purchases relative to the size of the markets for Treasury or agency securities could ultimately become an issue, few if any problems have been observed in those markets thus far.
A second potential cost of LSAPs is that they may undermine public confidence in the Federal Reserve's ability to exit smoothly from its accommodative policies at the appropriate time. Such a reduction in confidence might increase the risk that long-term inflation expectations become unanchored. The Federal Reserve is certainly aware of these concerns and accordingly has placed great emphasis on developing the necessary tools to ensure that policy accommodation can be removed when appropriate. For example, the Federal Reserve will be able to put upward pressure on short-term interest rates at the appropriate time by raising the interest rate it pays on reserves, using draining tools like reverse repurchase agreements or term deposits with depository institutions, or selling securities from the Federal Reserve's portfolio. To date, the expansion of the balance sheet does not appear to have materially affected long-term inflation expectations.
A third cost to be weighed is that of risks to financial stability. For example, some observers have raised concerns that, by driving longer-term yields lower, nontraditional policies could induce imprudent risk-taking by some investors. Of course, some risk-taking is a necessary element of a healthy economic recovery, and accommodative monetary policies could even serve to reduce the risk in the system by strengthening the overall economy. Nonetheless, the Federal Reserve has substantially expanded its monitoring of the financial system and modified its supervisory approach to take a more systemic perspective.
There has been limited evidence so far of excessive buildups of duration, credit risk, or leverage, but the Federal Reserve will continue both its careful oversight and its implementation of financial regulatory reforms designed to reduce systemic risk.4
The Federal Reserve has remitted substantial income to the Treasury from its earnings on securities, totaling some $290 billion since 2009. However, if the economy continues to strengthen and policy accommodation is withdrawn, remittances will likely decline in coming years. Indeed, in some scenarios, particularly if interest rates were to rise quickly, remittances to the Treasury could be quite low for a time.5 Even in such scenarios, however, average annual remittances over the period affected by the Federal Reserve's purchases are highly likely to be greater than the pre-crisis norm, perhaps substantially so. Moreover, if monetary policy promotes a stronger recovery, the associated reduction in the federal deficit would far exceed any variation in the Federal Reserve's remittances to the Treasury. That said, the Federal Reserve conducts monetary policy to meet its congressionally mandated objectives of maximum employment and price stability and not primarily for the purpose of turning a profit for the U.S. Department of the Treasury.
1. For a selective list of references regarding the effect of the first LSAP, see the box "The Effects of Federal Reserve Asset Purchases" in Board of Governors of the Federal Reserve System (2011), Monetary Policy Report to the Congress (Washington: Board of Governors, March), For additional references, including those that analyze the effect of the second LSAP as well as the maturity extension program, see, for example, Stefania D’Amico, William English, David López-Salido, and Edward Nelson (2012), "The Federal Reserve’s Large-Scale Asset Purchase Programmes: Rationale and Effects," Economic Journal, vol. 122 (November), pp. F415–45; Arvind Krishnamurthy and Annette Vissing-Jorgensen (2011), "The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy," Brookings Papers on Economic Activity, Fall, pp. 215–65; Canlin Li and Min Wei (2012), "Term Structure Modelling with Supply Factors and the Federal Reserve’s Large Scale Asset Purchase Programs," Finance and Economics Discussion Series 2012-37 (Washington: Board of Governors of the Federal Reserve System, May), and references in those studies. For work that specifically emphasizes the signaling channel of LSAPs, see, for example, Michael D. Bauer and Glenn D. Rudebusch (2012), "The Signaling Channel for Federal Reserve Bond Purchases," Working Paper Series 2011-21 (San Francisco: Federal Reserve Bank of San Francisco, August) For work that focuses on the effects on credit default risk, see, for example, Simon Gilchrist and Egon Zakrajšek (2012), "The Impact of the Federal Reserve’s Large-Scale Asset Purchase Programs on Default Risk," paper presented at "Macroeconomics and Financial Intermediation: Directions since the Crisis," a conference held at the National Bank of Belgium, Brussels, December 9–10, 2011. Although the majority of research on the effects of LSAPs appears to support a significant influence on asset prices, the overall result of such programs is generally difficult to estimate precisely: Event studies can make only sharp predictions on the effects within a relatively short time horizon, whereas approaches based on time-series models tend to face challenges in isolating the effects of the programs from other economic developments. For a more skeptical view on the effect of LSAPs, see, for example, Daniel L. Thornton (2012), "Evidence on the Portfolio Balance Channel of Quantitative Easing," Working Paper Series 2012-015A. (St. Louis: Federal Reserve Bank of St. Louis, October) Return to text
2. These results are discussed further in Hess Chung, Jean-Philippe Laforte, David Reifschneider, and John C. Williams (2012), "Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?" Journal of Money, Credit and Banking, vol. 44 (February supplement), pp. 47–82. Return to text
3. For studies reporting significant macroeconomic effects from asset purchases, see, for example, Jeffrey C. Fuhrer and Giovanni P. Olivei (2011), "The Estimated Macroeconomic Effects of the Federal Reserve’s Large-Scale Treasury Purchase Program," Public Policy Briefs 11-02 (Boston: Federal Reserve Bank of Boston, April) and Christiane Baumeister and Luca Benati (2012), "Unconventional Monetary Policy and the Great Recession: Estimating the Macroeconomic Effects of a Spread Compression at the Zero Lower Bound," Working Papers 2012-21. (Ottawa: Bank of Canada, July) Also, the Bank of England has implemented LSAPs similar to those undertaken by the Federal Reserve, and its staff research finds that the effects appear to be quantitatively similar to those in the United States. For studies reporting smaller effects from asset purchases, see, for example, Michael T. Kiley (2012), "The Aggregate Demand Effects of Short- and Long-Term Interest Rates," Finance and Economics Discussion Series 2012-54 (Washington: Board of Governors of the Federal Reserve System, August) and Han Chen, Vasco Curdia, and Andrea Ferrero (2012), "The Macroeconomic Effects of Large-Scale Asset Purchase Programmes," Economic Journal, vol. 122 (November), pp. F289–315. Return to text
5. For additional details, see, Seth B. Carpenter, Jane E. Ihrig, Elizabeth C. Klee, Daniel W. Quinn, and Alexander H. Boote (2013), "The Federal Reserve's Balance Sheet and Earnings: A primer and projections," Finance and Economics Discussion Series 2013-01 (Washington: Board of Governors of the Federal Reserve System, January). Return to text