Tuesday, September 4, 2012

What's in Bernanke's bag?

Excerpts from Chairman Ben S. Bernanke's speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 31, 2012: Monetary Policy since the Onset of the Crisis

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...

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.

What's in Bernanke's bag of tricks? Lowering interest rates, that's what.

Unfortunately, although it is likely that even worse outcomes had been averted, the damage to the economy was severe. The unemployment rate in the United States rose from about 6 percent in September 2008 to nearly 9 percent by April 2009--it would peak at 10 percent in October--while inflation declined sharply. As the crisis crested, and with the federal funds rate at its effective lower bound, the FOMC turned to nontraditional policy approaches to support the recovery.

...the FOMC has focused on the acquisition of longer-term securities...

...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.

Large-scale asset purchases ... can signal that the central bank intends to pursue a persistently more accommodative policy stance ... thereby lowering investors' expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates...

With the space for further cuts in the target for the federal funds rate increasingly limited, in late 2008 the Federal Reserve initiated a series of large-scale asset purchases (LSAPs). In November, the FOMC announced a program to purchase a total of $600 billion in agency MBS and agency debt. In March 2009, the FOMC expanded this purchase program substantially... These purchases were completed, with minor adjustments, in early 2010. In November 2010, the FOMC announced that it would further expand the Federal Reserve's security holdings ... over a period ending in mid-2011.

About a year ago, the FOMC introduced a variation on its earlier purchase programs, known as the maturity extension program (MEP), under which the Federal Reserve would purchase $400 billion of long-term Treasury securities and sell an equivalent amount of shorter-term Treasury securities over the period ending in June 2012. The FOMC subsequently extended the MEP through the end of this year. By reducing the average maturity of the securities held by the public, the MEP puts additional downward pressure on longer-term interest rates...

What's in Bernanke's bag? Lowering interest rates. But as I showed yesterday, interest rates have been trending down since the early 1980s. And so has growth.

Reducing the Federal Funds rate from 19% to nothing was a long-term act of desperation. It was an unsustainable attempt to boost economic growth. It failed.

Now that the rate has hit its lower bound, Bernanke is pulling all sorts of tricks out of his bag, in an attempt to reduce rates further, to boost growth.

Reducing interest rates to boost growth is a policy that has been failing for 30 years. Something else must be done. An alternative must be found.

Let me say it again: Rather than attempting to reduce interest rates further, we can lower the burden of financial cost by reducing the amount of outstanding private-sector debt. Policy must facilitate private sector deleverage. Give the private sector what it wants.

Relieve the private sector of half its debt. The economy will grow, then.

1 comment:

Jazzbumpa said...

It looks to me as though the Fed might have some traction in raising rates - though I am not convinced of it.

However, in lowering rates, the Fed is clearly a market follower: 3 mo T-bill rates, set by the "free market" go down faster than FF rates.

Generally, the FF rate is higher then the T-Bill rate by a few tenths. I want to take a close look to see if he Fed has any power when the FF rate is below the T-Bill rate.

My guess is no.