The arrival of short-term interest rates at the zero bound has changed U.S. monetary policy irrevocably. The Fed’s asset purchases have exceeded a quarter of concurrent GDP over the course of 6 years, compressing term and credit premiums by unprecedented margins, with no reversal in sight. Forward guidance has reduced market uncertainty and raised the credibility of a persistently expansionary stance. Excess stimulus and economic conditionality have become prevalent. The flipside is increased dependency of the financial system on the continuation of such accommodative conditions.
The basics in four paragraphs
The Federal Reserve pursues a monetary policy of “flexible inflation targeting“, seeking to bring both inflation and economic operating rates (particularly the unemployment rate) towards mandated levels over the medium term. Unlike many other central banks,, the Fed operates under an explicit dual mandate and has considerable flexibility regarding the time horizon for meeting its economic objectives. Within that mandate, the regime had to evolve rapidly in terms of tools and principles after the fed funds rate had reached an effective zero bound during the great financial crisis.
The Federal Reserve’s main tools have become 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 and probably 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 premiums, maybe in the range of 10-30 bps.
- Forward guidance typically means commitments to maintain accommodative conventional and unconventional policies for some time or until specific economic conditions would be met. Most notably, the Fed has set fairly specific necessary economic conditions for the fed funds rate to increase from its near-zero level (see below).
New key principles of policy execution have been 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 in the past under similar economic conditions. This reflects the asymmetric distribution of risk: at the zero bound: a deflationary surprise would be a greater problem than an inflationary surprise.
- History dependence means a promise of more monetary stimulus in the future if the economy has to accept deeper downturns as a consequence of short rates being constrained by the zero bound.
- Economic conditionality means that timing and size of upward adjustments in policy rates are tied to economic conditions. This is designed to help quelling market fears of premature monetary tighten.
The Fed’s highly stimulative non-conventional monetary has given rise to various concerns (see below). The most acute has been the rising addiction of the economy and financial system to ultra-easy refinancing conditions. 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).
A brief history of asset purchase and extension programs
First large-scale asset purchases (QE1)
The first large-scale asset purchases were launched in November 2008. The Federal Reserve Open Market Committee (FOMC) announced purchases 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 programs seem 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).
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“.
Second large-scale asset purchase program (QE2)
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.
Maturity extension program (Operation “Twist”)
Under the 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.
Open-ended asset purchases and “tapering” (QE 3)
In September 2012 the FOMC launched a new program, under which it would be purchasing agency mortgage-backed securities at a rate of USD40 bn per month. In December 2012 the committee added 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, 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 has stayed on this course of purchase volume reduction since then.
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.
A brief summary of the Fed’s forward guidance
Forward guidance 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 has been introduced in December 2008, has been modified several times subsequently and 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.
In December 2012 the FOMC indicated that the target range for the federal funds rate of 0-0.25% would be appropriate at least as long as (i) the unemployment rate remains above 6.5%, (ii) inflation between 1 and 2 years ahead is projected to be no more than 0.5%-points above the 2% longer-run goal, and (iii) longer-term inflation expectations continue to be well anchored.
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.
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.
For example, when 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).