The Fed’s Expanded Toolkit
August 28, 2016
“The Global Financial Crisis and Great Recession posed daunting new challenges for central banks around the world and spurred innovations in monetary policy. With the U.S. economy now nearing the Federal Reserve’s statutory goals of maximum employment and price stability, this conference provides a timely opportunity to consider how the lessons we learned are likely to influence the conduct of monetary policy in the future.”
These words are taken from the opening paragraph of Chair Yellen’s speech1 at Jackson Hole, Wyoming on August 26, 2016. I thought them most appropriate for the opening paragraph of this article, where I would like to summarize for you Yellen’s expose on the Fed’s “toolkit”.
Given the theme of the conference, “Designing Resilient Monetary Policy Frameworks for the Future,” and the “policy tools” focus of Yellen’s speech, I want to cover three relevant questions:
- What tools did the Fed have pre-crises?
- What new tools did the Fed implement to address the financial crises?
- What might a future toolkit look like?
The Fed’s Pre-Crises Toolkit
Before 2007 and the global financial crises, the Federal Reserve’s monetary policy toolkit was “simple but effective in the circumstances that then prevailed.” The main tool was primarily repurchase agreements based on treasury securities, or “open market operations”, used in regulating the amount of reserves available to banks.
In a type of domino-effect, open market operations influenced the interest rate in the federal funds market where banks could borrow from excess reserves of other banks. These Fed funds rate changes affected other short-term rates, which then affected longer-term rates, which affected general financial conditions, inflation and economic activity. If this sounds like a blind-pocket, over the eight-ball trick shot with back-handed English, I didn’t make it up.
“One lesson from the crisis is that our pre-crisis toolkit was inadequate to address the range of economic circumstances that we faced.” – Yellen
The financial crises exposed two major shortcomings:
- Inability to control the federal funds rate when reserves are plentiful
- Inability to generate significant accommodation beyond near-zero short-term rates
The danger after 2007 was that once credit flowed to households and businesses, the additional reserves would have pushed the short-term rates well below the target rate and beyond the Fed’s ability to control them. As it turned out, this was not a concern by the end of 2008 as many policy benchmarks would in hindsight have called for a substantially negative rate. Negative rates deemed impossible highlights the second limitation.
The Fed’s Expanded Toolkit
To address lessons learned from the financial crises and subsequent recession and slow recovery, the Federal Reserve made significant additions to its monetary policy toolkit. Three of these tools are:
- Pay interest on banks’ excess reserves
- Transact in large-scale asset purchases
- Provide explicit forward guidance (I’ve called “glasnost”)
Starting in October 2008, Congress allowed the Fed to pay interest on excess bank balances2. Paying interest on excess reserves was essential in enabling the Fed to control short-term interest rates when reserves were abundant by discouraging lending at rates substantially below that offered by the Fed – in essence putting a floor on rates.
After the short-term rate fell to near-zero, purchases of treasuries and mortgage-related securities pushed down longer-term rates for families and businesses. Extensive forward looking guidance by the FED regarding the scope of asset purchases and keeping short-term rates lower longer helped to put significant pressure on longer-term rates.
“Our understanding of the forces driving long-run trends in interest rates is nevertheless limited, and thus all predictions in this area are highly uncertain.” – Yellen
Has this new policy of asset purchases and forward guidance been effective? Some argue not, given the tepid recovery. Yellen points out that the criticism fails to consider the unusual headwinds we faced after the crises including:
- Substantial household and business deleveraging
- Unfavorable demand shocks from abroad
- Contractionary fiscal policy
- Unusually tight credit, especially for housing
Yellen cites studies which have found that “Our asset purchases and extended forward rate guidance put appreciable downward pressure on long-term interest rates and, as a result, helped spur growth in demand for goods and services, lower the unemployment rate, and prevent inflation from falling further below our 2 percent objective.”
Yellen continues, “Our current toolkit proved effective last December. In an environment of superabundant reserves, the FOMC raised the effective federal funds rate–that is, the weighted average rate on federal funds transactions among participants in that market–by the desired amount, and we have since maintained the federal funds rate in its target range.”
The Fed’s Toolkit Of The Future
Adjusting the Federal Funds rate will likely continue to be a key instrument in the Fed’s toolkit. At some point after increasing the Fed Funds rate is well under way, reinvestment and repayment of principal from asset purchases will be phased out.
The Fed has been studying the policy of allowing for negative rates, removing the near-zero constraint on the Federal Funds target rate. For now, Yellen maintains that its two most important new tools, large-scale asset purchases and the authority to pay interest on excess bank reserves, “Should be sufficient unless the recession were to be unusually severe and persistent.” Relying too heavily on nontraditional tools might “inadvertently encourage excessive risk-taking and so undermine financial stability.”
Yellen mentions additional tools which have been used by other central banks. She admits that although the FOMC is not actively considering them, they are “important subjects for research.” These include:
- Purchasing a broader range of assets
- Raising the FOMC’s 2% inflation objective
- Implementing alternative policy e.g. targeting price-levels or nominal GDP
The Challenge Ahead
For now, it seems as though the Fed has helped guide our economy away from a precipice, albeit not completely out of the woods. Ahead awaits the challenge of contracting the Fed’s balance sheet back to more normal levels without adversely increasing inflation pressures or destabilizing financial markets.
The Fed’s monetary policy toolkit will likely continue to include traditional tools which have helped the Fed respond to past crises in the past. New tools are being researched and debated for dealing with future downturns.
Studying the Fed’s speeches is a good way to learn what they are thinking beyond the media’s headline hyperboles. We intend to do just that for you here at Coherent.
Sargon Zia, CFA
August 28, 2016
You are welcome to comment!
- The full text of Chair Yellen’s speech is available at The Federal Reserve’s website. www.federalreserve.gov/newsevents/speech/yellen20160826a.htm
- Only depository institutions could earn interest on excessive reserves (IOER). The overnight reverse repurchase agreement (ON RRP) facility is available to a variety of counterparties, including eligible money market funds, government-sponsored enterprises, broker-dealers, and depository institutions. Through it, eligible counterparties may invest funds overnight with the Federal Reserve at a rate determined by the FOMC. Similar to the payment of IOER, the ON RRP facility discourages participating institutions from lending at a rate substantially below that offered by the Fed.
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