The Federal Reserve relied heavily on non-conventional monetary policy after the great financial crisis.  Most prominently it has purchased treasuries and mortgage-backed securities in excess of a quarter of concurrent GDP, compressing both term and credit risk premiums by unprecedented margins. Forward guidance for rates and asset purchases compounded the compression. Deflation risk and expectation management have led to new policy principles, such as excess stimulus. Side effects include the potential addiction of the financial system to highly accommodative conditions.

The very basics

Mandate and non-conventional policy tools

Unlike most central banks the Federal Reserve operates under an explicit dual mandate and pursues a monetary policy of “flexible inflation targeting“. This means it seeks to bring both inflation and economic operating rates (particularly the unemployment rate) towards mandated levels over the medium term. Moreover, the Fed has considerable flexibility regarding the time horizon for meeting its economic objectives.

Prior to the great financial crisis U.S. monetary policy set a target for the federal funds rate (an overnight interbank borrowing rate) and conducted small open market operations to keep rates close to the target. After reaching the zero lower bound for this rate the Federal Reserve’s main tools became non-conventional: large-scale asset purchases, duration extension operations, and interest rate forward guidance.

  • The three large-scale asset purchase programs conducted between 2008 and 2014 acquired government, housing agencies and mortgage back securities of approximately 25% of concurrent GDP. Estimates suggest that the programs reduced the 10-year term treasury yield premium somewhere in the range of 50-200 basis points (details on the programs below).
  • The smaller maturity extension program (“operation twist”) exchanged short-term for long-term government debt holdings in 2011/12 by an amount of just above 4% of GDP, further compressing term premia, maybe in the range of 10-30 bps.
  • Forward guidance means commitments to maintain accommodative conventional and unconventional policies for some time or until specific economic conditions would be met. In particular, the Fed has set fairly specific necessary economic conditions for the fed funds rate to increase from its near-zero level (see below).

New principles

Deflation risk and the proximity of the zero lower bound necessitated a focus on new key principles of policy execution. such as excess stimulus, history dependence, and economic conditionality (view post here).

  • Excess stimulus means that the monetary policy at the zero lower bound of the policy rate would be more expansionary than for positive rates under similar economic conditions. This reflects the asymmetric distribution of risk at the zero bound: a deflationary surprise would be much harder to correct than an inflationary surprise. Moreover, with insuffficiently accommodative policy the mere risk of being constrained by the zero bound tomorrow creates deflation expectations already today. Such expectations reinforce the severity of the zero rate constraint (view post here).
  • History dependence means that monetary policy must promise more monetary stimulus in the future if the economy experiences a deeper downturn at present. A credible promise can help reducing long-term nominal and real interest rates, mitigating the constraint imposed by the lower bound for interest rates.
  • Economic conditionality means that timing and size of upward adjustments in policy rates are tied to economic conditions. This conditionality helps to to pre-empt market fears of premature or excessive monetary tightening and ultimately increases the probability to move upward from the zero bound.

“The higher the probability of monetary policy becoming constrained by the zero lower bound…the more current policy should lean in accommodative direction.”

“Our actual policy actions over time will depend on how economic conditions evolve.”

Janet Yellen, Chair of the Board of Governors of the Federal Reserve System

Non-conventional policies since 2008

Large-scale asset purchase programs

The first large-scale asset purchases were launched in November 2008, when the FOMC announced the acquisition of housing agency debt and agency mortgage-backed securities (MBS) of up to USD600 bn (about 4% of GDP). In March 2009, the FOMC decided to substantially expand its purchases of agency-related securities and to acquire longer term Treasury securities as well, with total purchases targeting USD1.75 trn (12% of GDP.) This represented 22% of the outstanding stock of longer term agency debt, fixed-rate agency MBS, and Treasury securities.

By reducing the net supply of assets with long duration, the Federal Reserve’s LSAP [large-scale asset purchase] programs appeared to have successfully compressed the term premium charged on long-dated bond yields. Thus, the reduction in the ten-year term premium associated with LSAPs through March 2010 was estimated to be somewhere between 30 and 100 basis points (see post here). In addition, the LSAP program seems to have had an even greater effect on longer term interest rates of agency debt and agency MBS, by improving market liquidity and removing assets with high prepayment risk from private portfolios (view post here).

In November 2010 the FOMC initiated purchases of USD600 bn (4% of GDP) in longer-term Treasury securities while continuing to reinvest the proceeds of maturing or redeemed longer-term securities in Treasuries (QE2). The program was completed in June 2011.

Estimates based on a number of studies as well as Federal Reserve analyses suggest that QE2 lowered longer-term interest rates by approximately 10 to 30 basis points. The Federal reserve’s analysis further indicates that a reduction in longer-term interest rates of this magnitude would be roughly equivalent in terms of its effect on the economy to a 40 to 120 basis point reduction in the federal funds rate.

Under the 2011-12 maturity extension program, the Federal Reserve was selling or redeeming shorter-term government debt and using the proceeds to buy longer-term Treasury securities, extending the average maturity of the securities in the Federal Reserve’s portfolio. In September 2011 the FOMC announced a USD400 billion (2.6% of GDP) program that would be completed by the end of June 2012. In June 2012, the FOMC extended the program to the end of 2012, which resulted in the purchase of an additional USD267 billion (1.7% of GDP) in Treasury securities.

According to the Fed this maturity extension was intended to put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, would contribute to a broad easing in financial market conditions.

In September 2012 the FOMC launched an open-ended asset purchase program, under which it would be acquiring agency mortgage-backed securities at a rate of USD40 bn per month. In December 2012 the committee announced that would also buy long-term Treasury securities at a pace of USD45 bn per month (following the conclusion of the Maturity Extension Program). As consequence of these decisions the pace of securities purchases was set at USD85 bn per month (or 6-7% of U.S. GDP at an annualized rate). While the FOMC did not set a ceiling or expiry for the program it emphasized that “purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on its outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.”

In mid-2013, the FOMC indicated that if progress toward its objectives continued as expected, a moderation in the monthly pace of purchases (“tapering”) would likely become appropriate later in the year. In December 2013, the FOMC finally concluded that the cumulative progress of economic recovery warranted a reduction in the pace of purchases, by USD10 bn (USD  5bn  each in long-term Treasury securities and agency MBS). The Committee stayed on this course and terminated the program in October 2014.

Federal Reserve “tapering” has been predicated on five principles (view post here): (a) balance sheet expansion would slow and ultimately cease if unemployment declines on a sustained basis to around 7%, (b) the pace of asset purchases remained data dependent, hinging on sustained labor market improvement and financial conditions, (c) tapering was not meant to tighten monetary conditions, (d) tapering would not per se lead to subsequent unwinding of Treasury holdings and may never result in MBS sales, and (e) tapering would not per se bring forward Fed fund rate hikes, which are subject to higher thresholds.

N.B.: Most economists argue that by purchasing a particular asset, a central bank reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others, while simultaneously increasing the amount of short-term, risk-free bank reserves held by the private sector. In order for investors to be willing to make those adjustments, the expected return on the purchased security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. This pattern is commonly known as the “portfolio-balance effect“.

Forward guidance

Forward guidance generally denotes a commitment to maintain conventional and non-conventional policies for a specific period of time or until specific conditions have been met. Forward guidance for the fed funds rate was introduced in December 2008  and has been modified several times subsequently but has effectively been preserved until the present day (view post here). An important evolution during this time was the transition from fixed time or quantity guidance to conditionality on economic developments, in order to turn Fed communication into an automatic stabilizer for market expectations.

For example, in March 2014, with the unemployment rate approaching 6.5%, the FOMC specified that “in determining how long to maintain the current 0-0.25% target range for the federal funds rate, the Committee will assess progress toward its objectives of maximum employment [5.2-5.6% unemployment rate] and 2 percent inflation.” Similarly, the FOMC communicated that “it expects a highly accommodative stance of monetary policy to remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.” The open-ended asset purchase program in turn has been tied to the dynamics of the labor market and inflation. Sometime after than program ceased acquiring more assets, policy rates could rise, but that increase would be tempered by both economic and financial conditions (view post here). A reversal of asset purchases would follow the normalization of policy rates.

“By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates”

Federal Reserve Board

Side effects

Economic and financial side effects

Empirical research suggests that the Fed’s highly stimulative non-conventional monetary policy compressed both term-premia and credit spreads (view post here on how this worked). Thereby it contributed to the post-crisis economic and financial recovery in the U.S. and globally. However, its innovative and aggressive format has also given rise to severe potential side-effects.

  • The main concern is the rising addiction of the economy and financial system to ultra-easy refinancing conditions, also outside outside the U.S. due to the global importance of dollar lending (view post here). Meanwhile, exiting or reversing non-conventional policy is not straightforward in a financial system that is reliant on monetary support. For example, when the FOMC simply announced a “tapering” of their asset purchases in May 2013, i.e. a reduction of the pace of accumulation, U.S. 10-year swap yields surged from 180bps to over 280s in less than two months with huge repercussions on long-dated yields around the world. This market shock occurred even though the FOMC merely specified a response to stronger economic developments, with no intention to tighten monetary conditions (view post here). The Federal Reserve has acknowledged its influence on risk taking, its position is that macroprudential, not monetary policy would be best suited to address the issue (view post here).
  • Non-conventional policy did not only work towards the desired reduction in term and risk premia but also has affected financial market structure and created new risks (view post here). Thus, non-conventional policies have partly replaced traditional interbank and money market activity. The business model of money market mutual funds has been severely challenged, resulting in asset shrinkage and rising credit risk taking.
  • Also, the Fed has become a dominant player in the U.S. MBS [mortage-backed securities] market, and a major holder of government debt. The politically mandated biases in market prices could unwind disorderly if and when economic development mandates a reversal of non-conventional policies. This risk reflects the sensitivity of yield term premia, not just to expected short-term rates, but to macroeconomic changes, market volatility, and the pace of asset purchases (view post here). Theoretical research underscores that bond markets that are uncertain about the fundamental environment and depend critically on public information (such as central bank announcements) are more prone to herding and instability.

On a more technical note, the large asset purchase programs have left the U.S. banking system with USD2.6 trn in (mostly excess) reserves compared to just USD14 billion before the great financial crisis. Since the Fed has decided in principle to implement future tightening through adjusting the federal funds target rate before any asset sales, this implies that if and when the policy rate will be hiked, it will amid in a market with huge excess liquidity. Hence, raising the target federal funds rate would rely primarily on increases in the interest rate paid on excess reserves (view post here). Moreover, in order to secure a sufficiently pervasive impact, reverse repurchase agreements would set a floor for the actual fed funds rate. Their exact form will influence whether or not the target floor on money market rates will be “leaky” (view post here).

“Protracted very low rates precipitate financial instability by increasing capitalization ratios, raising the duration of assets, encouraging risk taking to chase yield and reducing…financial discipline.”

Larry Summers