It’s depressing in more ways than one. Although among other things that were absent in his speech, that I will get to later, it is more of an inquisitive speech, rather than the stern, obsessed with inflation and inflation fighting credibility speech that we’ve often heard from various Fed insiders over the past few years. Perhaps it should be an encouraging sign of change, but I don’t have that much patience (left).
Here’s Bernanke [notations omitted throughout]:
When we convened in Jackson Hole in August 2007, the Federal Open Market Committee’s (FOMC) target for the federal funds rate was 5-1/4 percent. Sixteen months later, with the financial crisis in full swing, the FOMC had lowered the target for the federal funds rate to nearly zero, thereby entering the unfamiliar territory of having to conduct monetary policy with the policy interest rate at its effective lower bound. The unusual severity of the recession and ongoing strains in financial markets made the challenges facing monetary policymakers all the greater.
Today I will review the evolution of U.S. monetary policy since late 2007. My focus will be the Federal Reserve’s experience with nontraditional policy tools, notably those based on the management of the Federal Reserve’s balance sheet and on its public communications. I’ll discuss what we have learned about the efficacy and drawbacks of these less familiar forms of monetary policy, and I’ll talk about the implications for the Federal Reserve’s ongoing efforts to promote a return to maximum employment in a context of price stability.
Here’s where my spirits picked up. I thought “Wow! The mea culpa we’ve been waiting for and an announcement that the old regime is no longer appropriate to measure against.” But there’s no such luck. He brushes right over the cause of the severity of the recession as if the Fed were unintentionally a hapless bystander.
When significant financial stresses first emerged, in August 2007, the FOMC responded quickly, first through liquidity actions–cutting the discount rate and extending term loans to banks–and then, in September, by lowering the target for the federal funds rate by 50 basis points. As further indications of economic weakness appeared over subsequent months, the Committee reduced its target for the federal funds rate by a cumulative 325 basis points, leaving the target at 2 percent by the spring of 2008.
The Committee held rates constant over the summer as it monitored economic and financial conditions. When the crisis intensified markedly in the fall, the Committee responded by cutting the target for the federal funds rate by 100 basis points in October, with half of this easing coming as part of an unprecedented coordinated interest rate cut by six major central banks. Then, in December 2008, as evidence of a dramatic slowdown mounted, the Committee reduced its target to a range of 0 to 25 basis points, effectively its lower bound. That target range remains in place today.
Didn’t he leave out an increase in the FF rate in April 2008 and threats to keep raising it because of risks toward inflation from oil prices even though the dollar was appreciating against all major currencies? He also leaves out the implementation of IOR and IOER in late 2008 that negates the increased opportunity cost of holding M2.
Despite the easing of monetary policy, dysfunction in credit markets continued to worsen. As you know, in the latter part of 2008 and early 2009, the Federal Reserve took extraordinary steps to provide liquidity and support credit market functioning, including the establishment of a number of emergency lending facilities and the creation or extension of currency swap agreements with 14 central banks around the world. In its role as banking regulator, the Federal Reserve also led stress tests of the largest U.S. bank holding companies, setting the stage for the companies to raise capital. These actions–along with a host of interventions by other policymakers in the United States and throughout the world–helped stabilize global financial markets, which in turn served to check the deterioration in the real economy and the emergence of deflationary pressures.
It’s interesting that there is no mention of deflation or the collapse in NGDP when we know it happened some time before all of these conditions were in “full swing”. I suppose it is unbecoming of a central banker to admit he and his colleagues were screaming fire in Noah’s flood. What do stress tests do for deflation and a collapse in NGDP anyway when the price stability and full employment mandates make pretty clear where the focus of the Fed should be? He also doesn’t mention who, when there is a mad rush for liquidity, would invest in a banking system that the Fed allowed to get flushed down the vortex of the giant crapper from hell. Not only were these guys (and gals) screaming fire in the flood, they were trying to hold the tsunami back with a Swiffer.
Here’s more from Bernanke talking about balance sheet tools for conducting monetary policy at the lower bound:
Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy. Following this logic, Tobin suggested that purchases of longer-term securities by the Federal Reserve during the Great Depression could have helped the U.S. economy recover despite the fact that short-term rates were close to zero, and Friedman argued for large-scale purchases of long-term bonds by the Bank of Japan to help overcome Japan’s deflationary trap.
I might be wrong about this, but I think he misses the point Friedman was making about the reasons the BoJ should conduct large-scale purchases of long-term bonds to get out of the deflationary trap. It would not have mattered what the BoJ bought or if it dropped money from helicopters. What matters is making up for undershooting. What matters is makeup growth, stabilizing spending or demand back to trend. He knows this, and I am shocked by this bastardization of not only Friedman’s scholarship, but his own.
Here’s more Bernanke:
Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about “tail” risks such as deflation. During stressful periods, asset purchases may also improve the functioning of financial markets, thereby easing credit conditions in some sectors.
I am not really criticizing Bernanke’s explanation of how LSAPs work here, but the modifiers seem distorted considering the limited and rather feckless way in which the programs were conducted. This seems a bit like Pollyanna – households will be extremely confident we aren’t getting more deflation. That sure takes a load off my mind when I’m worried about keeping my job or finding another one, or losing my house and everything else I’ve spent a lifetime working for. Sure, things can always be much worse than they are, money and cash substitutes could disappear from the planet tomorrow, but shouldn’t we expect more from the Fed that is supposed to be “managing monetary and credit aggregates commensurate with the economy’s long-term ability to increase production, so as to promote the goals of full employment, price stability, and moderate long-term interest rates”? Sorry if I seem like a real ass with this, as he seems to be coming around very slowly, but just preventing deflation isn’t consistent with the law and I think that needs to be more clear.
How effective are balance sheet policies? After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points. Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield.13 These effects are economically meaningful.
Flight to safety is really good at lowering Treasury yields also. I don’t understand the obsession with lowering yields on Treasuries and long-term interest rates, or how time and quantity-boxed LSAP programs are as effective as they could otherwise be. This seems like a person who is looking for a solution with formulas while forgetting about managing the expectations channels to make the hot potato even hotter. Perhaps his plans keep getting blunted by the value of safety being greater than risk for a return, and with no stated goal in mind, losses after the program expires are a real possibility given the amount of financial instability floating around the globe and little confidence that the Fed will arrive on time with help.
Now Bernanke talks about communication tools:
Clear communication is always important in central banking, but it can be especially important when economic conditions call for further policy stimulus but the policy rate is already at its effective lower bound. In particular, forward guidance that lowers private-sector expectations regarding future short-term rates should cause longer-term interest rates to decline, leading to more accommodative financial conditions.
But what happens those expectations have no observable effect on other aggregates like NGDP in the short run? Is it still a viable assumption to make that monetary policy is highly accommodative when there is little evidence this is occurring? If this worked, then promising to leave the FF rate at zero for a decade should really do the trick and get everyone back to work. Just maybe it doesn’t work, like it didn’t for Japan, while money is still too tight and forecast to be tight for 27 years, judging by the yield on the 2010 vintage 30-year Treasury bond. Perhaps this kind of communication tells the markets instead that the Fed isn’t and won’t be serious about achieving an economic recovery until 2014 or later, or maybe even never. Of course that is the glass half empty view of the world, but it is just as plausible as the other interpretation.
Bernanke then continues by discussing the cost-benefit analysis on unconventional tools. I’m not going to put the all the quotes in, just this next one, and you can read the rest from the original text if you want.
As I have discussed today, it is also true that nontraditional policies are relatively more difficult to apply, at least given the present state of our knowledge. Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain, and the use of nontraditional policies involves costs beyond those generally associated with more-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally: Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes.
I find it remarkably pathetic how these things sound compared to the supposed benchmark of “traditional policy tools” given that large scale deflationary events throw them way off course, and end up being quite risky and costly in themselves. Bernanke compares unconventional tools to regular tools as if there is a choice involved, as if traditional tools are optimal and worth pursuing. It’s almost as if he is saying “If we could do it this way…” But he can’t do it that way because that “traditional” framework was unsustainable and it stopped with a spectacular collapse. We are no longer living in that world where it worked. If he is so hooked on it, perhaps the better idea would be to go full bore on open-ended QE until interest rates rise to the point the FF rate can be adjusted. Otherwise he needs to find another pathway out rather than daydreaming about what once was while we all suffer and zero interest rate guidance keeps being extended for… for forever just like in Japan. Pathetic. Narrow. Minds. On FOMC. Hurts. Everyone. Greatly.
And to demonstrate the degree of pathetic, he closes with this:
As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.
Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.
Yeah, as needed. Where have we heard this before? SSDD.