Academic journal article Economic Commentary (Cleveland)

Unconventional Monetary Policy Measures and Inflation Expectations

Academic journal article Economic Commentary (Cleveland)

Unconventional Monetary Policy Measures and Inflation Expectations

Article excerpt

After its conventional monetary policy tool, the federal funds rate, hit the zero lower bound, the Federal Reserve implemented a number of new tools, including large-scale asset purchases, to provide stimulus to the economy in the Great Recession and the subsequent slow recovery. Such measures caused an unprecedented increase in the Fed's balance sheet and led some to fear that high inflation would soon follow. In this Economic Commentary, we argue that historical data for various measures of expected inflation did not provide any support for those fears. In addition, a look at the past six years shows that these fears have not materialized.

Unusual Times and the Expansion of the Fed Balance Sheet

Figure 1 shows the severity of the Great Recession in terms of the output gap, the difference between actual and potential output (GDP). A negative output gap refers to a period in which the economy produces less than its potential, and the Great Recession was associated with an exceptionally large and persistent negative output gap. The recovery that followed has also been slow. According to the estimate published by the Congressional Budget Office (CBO), the output gap bottomed out in 2009:Q2 but still has not turned positive more than five years into the recovery. Figure 2 shows that the Federal Open Market Committee (FOMC) responded to the financial crisis and the recession by cutting the federal funds rate target, finally dropping it to a range between zero and 0.25 percent on December 16, 2008.

In addition, at the peak of the financial crisis, the Federal Reserve also introduced its first Large-Scale Asset Purchases (LSAP) program, or quantitative easing (QE), through which it would purchase agency debt, agency mortgage-backed securities (MBS), and long-term Treasury securities. Since then, it has introduced several unconventional policy measures, as there was no room to stimulate the economy with further rate cuts. The direct and easily observable outcome of these measures was a record increase in the Fed's balance sheet-it nearly quintupled between September 2008 and December 2014.1 According to the quantity theory of money, an increase in the money supply leads to an equal increase in prices (assuming other tilings stay constant). Some people feared that the increase in the Fed's balance sheet would eventually be reflected in inflation of a similar magnitude.

We are interested in whether those fears were supported in survey or market measures of inflation expectations. To answer that question, we look at these expectations measures at various points in time around three major policy changes, namely the first, second, and third rounds of the LSAP program (QE1, QE2, and QE3). The points at which we check inflation expectations are those when the program was signaled or announced, as well as 3 and 6 months after the program was put into effect. The choice of the 3- and 6-month periods is arbitrary; nevertheless, they should still reflect any changes that the survey participants and market players had in their outlook after the policies started.

Since some rounds of QE were introduced in stages, we date the 3- and 6-month points from the time of the last announcement for that particular round. For example, the first round, QEI, started with the purchase of agency debt and agency MBS in November 2008 and continued with the purchase of long-term Treasury securities in March 2009, so we date it from March 2009. In table 1, we show the signaling and announcement dates for each round of QE. The Fed adopted other unconventional policy tools like forward guidance and the Maturity Extension Program (Operation Twist), but we focus on QE because it affects the size of the balance sheet directly. Forward guidance has no direct effect on the balance sheet, while Operation Twist affected only the composition of the balance sheet.

For each round of QE, we summarize the economic conditions around the time it was introduced. …

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