Academic journal article Current Politics and Economics of the United States, Canada and Mexico

Federal Reserve: Unconventional Monetary Policy Options *

Academic journal article Current Politics and Economics of the United States, Canada and Mexico

Federal Reserve: Unconventional Monetary Policy Options *

Article excerpt


In the aftermath of the financial crisis of 2007-2008, the Federal Reserve (Fed) reduced the federal funds rate to a range of 0% to 0.25% by December 2008, exhausting its conventional monetary tool.1 With the economy still exhibiting large amounts of slack and recovery prospects weak, the Fed experimented over the next few years with unconventional policies in an attempt to revive the economy. These policies were pursued after the acute crisis phase, during which the Fed created a series of emergency liquidity facilities; a discussion of these facilities is beyond the scope of this report.2 The dates and nature of the policy announcements are outlined in Table 1.

Although the policies had never been used before the crisis, they had been considered for some time. In a 2004 working paper, Ben Bernanke, then-Fed governor, and co-authors found "some grounds for optimism about the likely efficacy of non-standard policies" that central banks could use for stimulating the economy when the short-term policy interest rate (the federal funds rate, in the United States) has hit the "zero lower bound" and cannot be reduced to provide further stimulus. Although the zero-bound problem had been present in Japan for some time when the paper was published, "for more than a few generations of economists, [it] seemed to be a relic of the Depression era" in the United States. The paper grouped the non-standard policies into three classes:

(1) using communications policies to shape public expectations about the future course of interest rates; (2) increasing the size of the central bank's balance sheet, or "quantitative easing"; and (3) changing the composition of the central bank's balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the longterm interest rate.4

In the aftermath of the crisis, the Fed under Bernanke would use all three types of policies. For communication policies, the Fed introduced "forward guidance," first announcing in December 2008 that it would likely keep the federal funds rate "exceptionally low...for some time." This eventually evolved into a specific time horizon for how long rates would be kept "exceptionally low." In its October 2012 statement, it anticipated that the federal funds rate would be exceptionally low "at least through mid-2015." In December 2012, the Fed moved away from a time horizon for exceptionally low rates, instead tying the duration of exceptionally low rates to an economic threshold, namely as long as the unemployment rate remains above 6.5% and inflation and inflation expectations remain low. For increasing the balance sheet, the Fed has undertaken three rounds of large-scale asset purchases, popularly known as "quantitative easing" (QE).5 By purchasing Treasury securities, agency debt securities, and agency mortgage-backed securities (MBS), the Fed has increased the size of its balance sheet from less than $0.9 trillion in 2007 to about $4 trillion at the end of 2013.6 For changing the composition of the balance sheet, the Fed has undertaken the "Maturity Extension Program," under which the Fed purchased $667 billion in long-term U.S. Treasury securities, and sold an equivalent amount of short-term Treasury securities.

Since enactment of the mandate, Congress has largely deferred to the Fed on how to achieve the goals of maximum employment and stable prices, and therefore has had little input in the Fed's decisions to pursue unconventional policies. It maintains oversight responsibilities, however, and Congress has been interested in whether the Fed's unconventional policies have been consistent with its mandate.

The remainder of this report analyzes the economic effects of these programs, the current economic context in which these policies have been adopted, policy alternatives that the Fed has not pursued to date and their potential effects, potential legislative options for restricting the Fed's pursuit of unconventional monetary policy, and issues surrounding the eventual "exit strategy" from unconventional policy. …

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