Federal Reserve

The Federal Reserve relied heavily on non-conventional monetary policy after the great financial crisis, purchasing treasuries and mortgage-backed securities in excess of a quarter of concurrent GDP. In conjunction with various forms of forward guidance it compressed both term and credit risk premiums by unprecedented margins. The Federal Reserve has also been the first large central bank to begin reversing ultra-easy monetary policy. The initial focus is on a normalization of interest rates, while any reduction of the Fed’s huge balance sheet is more uncertain and a matter for the further future. The prime focus remains on downside or deflationary risks for the economy, while considering the inconvenient side effects for the global economy. The latter include growing addiction to cheap funding and challenges to the business model of financial institutions.

The very basics

Flexible dual mandate and market focus

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 promote financial conditions that would 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.

For the transmission of monetary policy to the boarder economy the Federal Reserve must pay particularly close attention to financial market conditions. As William Dudley of the New York Federal Reserve put it: “Divergences between short-term interest rates and financial conditions often appear to be larger and more persistent in the United States than in most other advanced economies. There are several reasons for this. First, the U.S. financial system depends less on its banking system to intermediate financial flows…Second,…U.S. residential housing is financed mainly by 30-year fixed-rate mortgages, rather than—as is the case in most other countries—adjustable-rate mortgages with rates that much more closely track their central banks’ short-term interest rate targets. Third, the equity market plays a much more important role in the United States than elsewhere.”

Federal Reserve policy must consider the influence of financial markets on several levels. According to the New York Fed’s head of markets group Simon Potter, “for monetary policy to achieve its objectives, markets must function well enough to transmit the stance of policy, both from the markets in which the Federal Reserve directly transacts to its policy target [the fed funds rate], and then onward from that target to other money markets, and eventually to those asset prices which directly affect real activity.”

“In a nutshell, the Fed’s goal is to promote financial conditions conducive to maximum employment and price stability.”

Janet Yellen

“Because the evolution of financial conditions can diverge from the path of the federal funds rate, financial conditions need to be carefully considered in the conduct of monetary policy.”

William Dudley

Operational targets

Prior to the great financial crisis the Federal Open Market Committee (FOMC) managed a single operational target: the federal funds rate. This rate measures the borrowing costs of banks for unsecured overnight loans from other banks and from government-sponsored entities. Since the Federal Reserve does not directly transact in these markets it relies upon a predictable relationship between its policy rates and the federal funds rate, which in turn relies on functioning money markets.

After reaching the zero lower bound for this rate the Federal Reserve’s main operational targets became non-conventional:

  • 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 introduced 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).

These non-conventional operations did not only represent powerful policies in their own right, but also changed the operating framework for conventional interest rate policy.

  • Before the great financial crisis the Federal reserve kept reserve balances scarce. Banks needed some reserves for operational liquidity and to satisfy mandatory requirements and their demand for reserves was decreasing with borrowing costs. Hence the Federal Reserve would steer the level of the federal funds rate by forecasting the level of reserves in the market that would achieve the desired level and then adjusting reserve supply to the system accordingly.
  • In the wake of the Federal Reserve’s asset purchases reserves became superabundant, fluctuating around USD2000 billion, compared to USD10 billion dollars in mid-2007. Hence, interest rate policy now relies on remuneration of excess reserves in form of two overnight facilities both of which are designed to put a reliable floor on interest rates: interest on reserves and the overnight reverse repurchase agreement facility. Interest on reserve is available only to depository institutions, while the overnight reverse repurchase agreement is accessible for broader range of counterparties. The reverse repurchase facility is intended to enhance competition in money markets, strengthen the transmission of the interest on reserves and to act as a “shock absorber”.

Policy principles

Risk management

Deflation fears and the proximity of the zero lower bound necessitated a much greater focus on “downside risk” for the economy. As Chicago Fed president Charles Evans pointed out: “There is less room to reduce policy rates when, sometime in the future, the need will inevitably arise. Accordingly, risk-management considerations point policy toward lowering the chance that policymakers again will face difficult zero-lower bound outcomes in the future.” Such risk considerations have given rise to new key principles of policy execution (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. As the FOMC stated repeatedly: “The actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.” This conditionality should help to pre-empt market fears of premature or excessive monetary tightening and ultimately increases the probability to move upward from the zero bound. The vice chair of the Federal Reserve Stanley Fisher emphasized that “it is hard to argue that predictability in our reaction to economic data could be anything but positive.”

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

Janet Yellen

Normalization principles

The United States have been the first large developed economy to begin rolling back ultra-accommodative monetary conditions. After terminating asset purchases the first step of actual reversal has been a gradual increase in short-term interest rates. Fed governor Lael Brainard explained this priority: “With a low U.S. neutral rate, conventional U.S. monetary policy does not have as much room as it did prior to the financial crisis to counter adverse shocks from abroad…the Federal Open Market Committee (FOMC) decided to delay balance sheet normalization until the federal funds rate had reached a high enough level to enable it to be cut materially if economic conditions deteriorate, thus guarding against the risk of returning to the effective lower bound.” Boston Fed CEO Eric Rosengren also added the point of familiarity: “In contrast to balance sheet…central banks have significant historical experience with moving short-term interest rates to achieve macroeconomic objectives. As a consequence, it makes sense to continue to use short-term interest rates as the primary tool for monetary policy.”

Balance sheet reduction seems to be a very long term prospect with uncertain parameters. Janet Yellen’s comments underscore this point: “The longer-run normal level of reserve balances will depend on a number of as-yet-unknown factors…The Committee currently anticipates reducing the quantity of reserve balances to a level that is appreciably below recent levels but larger than before the financial crisis.” As to the process of normalization the focus should initially be on re-investment policies. In Janet Yellen’s words “The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. Initially, these caps will be set at relatively low levels to limit the volume of securities that private investors will have to absorb.”

Also, balance sheet adjustments may need great caution and consistency, with less discretionary scope as in the case of policy rate setting. As Kansas City fed president Esther George put it: “Balance sheet adjustments will need to be gradual and smooth, which is an approach that carries the least risk in terms of a strategy to normalize its size. Importantly, once the process begins, it should continue without reconsideration at each subsequent FOMC meeting. In other words, the process should be on autopilot and not necessarily vary with moderate movements in the economic data. To do otherwise would amount to using the balance sheet as an active tool of policy outside of periods of severe financial or economic stress, and would increase uncertainty rather than reduce it.”

“Changing the target range for the federal funds rate is our primary means of adjusting the stance of monetary policy. In other words, we do not intend to use the balance sheet as an active tool for monetary policy in normal times.”

Janet Yellen

Non-conventional policies since 2008

Balance sheet expansion

Large scale asset purchases and the expansion of the Federal Reserve’s balance sheet have been the most influential monetary policy tool since the great financial crisis. A paper by John Williams compiles the results from a range of studies estimating the effect of the Federal Reserve’s large-scale asset purchases. While the exact numbers vary and are subject to substantial uncertainty, typical estimates of the effect of a representative $600 billion in Treasury puchases on long-term yields are in the range of 15 to 25 basis points, an effect roughly equivalent to that of three or four rate cuts of 25 basis points.

Large-scale asset purchases stopped in 2014, but their influence remains strong into the future:

  • Firstly, the sheer size of the Fed balance sheet means that its management retains powerful influence on monetary policy. As Kansas City Fed president Esther George pointed out: “Today, conducting monetary policy is considerably more complicated, owing in part to the size and composition of the Federal Reserve’s balance sheet. Prior to the financial crisis and recession, the Fed’s balance sheet was slightly less than USD1 trillion with a portfolio of short-term Treasuries. Over the period from 2009 to 2014, a series of large-scale asset purchases swelled the balance sheet to nearly USD4.5 trillion [about a quarter of GDP], and the portfolio shifted to include mortgage-backed securities and long-term Treasuries.”
  • Second, it is quite likely that asset purchases will be necessary in future economic downturns. This reflects mainly the proximity and constraint of the lower bound for policy rates. Chicago Fed president Charles Evans emphasized: “The trend rate of economic growth in the U.S. is much lower now than it was during…earlier episodes. For example, our Chicago Fed estimate for trend growth is currently 1-3/4 percent…All else being equal, in a low-trend-growth environment, short-term real interest rates will be lower…By one estimate made by colleagues Thomas Laubach and John Williams…the real neutral federal funds rate averaged 3.4 percent over the 1970s, 1980s and 1990s in the U.S.; today, the real neutral fed funds rate is estimated to be only 20 basis points and will likely remain low for some time to come….Taken at face value, this means that from comparable starting points, conventional monetary policy has 325 basis points less room to react to negative aggregate demand shocks than it had during the earlier period. “

“While the extensive use of central bank balance sheets has been a distinguishing feature of the most recent downturn and slow recovery, I see it as quite likely that this tool will be necessary in future economic downturns.”

Eric Rosengren

Box: 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 policy into an automatic stabilizer for market expectations.

Forward guidance provided two apparent benefits. First, it enhanced the effectiveness of accommodative Fed policies, such as low interest rates, by influencing the expectations of markets and the broader public. Second, it reduced market uncertainty. Stanley Fischer emphasized the importance of the latter: “Monetary policy implementation relies importantly on the management of market expectations…Clarity about the central bank’s reaction function–that is, how the central bank adjusts the stance of monetary policy in response to changing economic conditions–allows the market to alter financial conditions smoothly.”

“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, the policy’s innovative and aggressive format has also given rise to severe potential side-effects.

  • The main concern is that the global economy and financial system have grown addicted to ultra-easy refinancing conditions, due to the worldwide importance of dollar lending (view post here). Exiting or reversing non-conventional policy is hazardous in a financial system that is reliant on monetary support. As Fed Vice Chairman Stanley Fischer put it: “Excessive leverage and reliance on short-term funding, which may reward risk takers whose bets pay off, may also increase the risk of fire sales and contagion, creating a fragile financial situation.”
    For example, when the FOMC announced a mere “tapering” of their asset purchases in May 2013 (a reduction of the pace of asset purchases), 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 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, but its position is that macroprudential, not monetary policy would be best suited to address the issue (view post here).
  • Non-conventional policy has affected financial market structure and created new headwinds (view post here). Fed governor Jerome Powell pointed out: “Over time, low rates can put pressure on the business models of financial institutions…Low long-term interest rates have weighed on profitability in the financial sector…Net interest margins…have moved down for the largest banks…Life insurers have substantially underperformed the broader equity market since 2007, suggesting that investors see the low-rate environment as a drag on profitability for the industry. ”
    Also, 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.
  • The Fed has become a dominant player in the U.S. mortage-backed securities market, and a major holder of government debt. Its actions created market price subsidies. These subsides can unwind disorderly. Credit and term spreads are sensitive, not just to expected short-term rates, but also 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