Federal Reserve

The Brave New World of Monetary Policy Operations

Prior to the Lehman failure in 2008, the Federal Reserve controlled the federal funds rate through open market operations that added to or subtracted from the excess reserves that banks held at the Fed. Because excess reserves typically were only a few billion dollars, the funds rate was very sensitive to small changes in the quantity of reserves in the system.

The Fed’s response to Lehman and its aftermath included large-scale asset purchases that led to a thousand-fold increase in excess reserves. Consequently, since 2008, small open-market operations of a few billion dollars no longer alter the federal funds rate. Instead, the Fed introduced administered rates to change its policy stance. The most important of these—the interest rate that the Fed now pays on excess reserves (IOER)—sets a floor below which banks will not lend to other counterparties (since an overnight loan to the Fed is the safest rate available).

Until very recently, the Fed’s ability to control the federal funds rate seemed well in hand….

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Communicating Monetary Policy Uncertainty

When it comes to forecasting, we usually cite famous Yankee catcher and baseball philosopher Yogi Berra, who reputedly said: “It's tough to make predictions, especially about the future.”

For central bankers, this is more than just a minor headache. Given the lags between policy actions and their effects, forecasting is unavoidable. That puts uncertainty about the economic outlook at the heart of the policymakers’ daily job. Indeed, no one knows the future path of the economy or interest rates—not even those making the decisions.

Communicating this inevitable monetary policy uncertainty is difficult, but essential. In the United States, the Federal Open Market Committee (FOMC) uses a variety of means for this purpose. In two earlier posts, we discussed the evolution of FOMC communications and the usefulness of the quarterly survey of economic projections (SEP). Here, we examine a key aspect of FOMC communications that receives insufficient attention: the explicit publication of policymakers’ range of uncertainty about the future path for the policy rate. Buried near the end of the FOMC minutes, published three weeks after the SEP release, this information is consumed only by die-hard devotees….

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Qualifying for the Fed

Monetary economists of nearly all persuasions are overwhelming in their condemnation of President Trump’s desire to appoint Stephen Moore and Herman Cain to vacant seats on the Board of Governors of the Federal Reserve. The full-throated case for a high-quality Board offered by Greg Mankiw—former Chief of the Council of Economic Advisers under President George W. Bush—is just one compelling example.

Rather than review President Trump’s picks, in this post we enumerate the key qualities that we believe make a person well suited to serve on the Board. Before getting to any details, we should emphasize our strongly held view that there is no simple prescription—in law or practice―for what makes a successful Federal Reserve Governor. Furthermore, no single person combines all the characteristics needed to make for a successful Board. For that, diversity in thought, preferences, frameworks, decision-making, and experience is essential.

With the benefits of diversity in mind, we highlight three common characteristics that we consider vital for anyone to be an effective Governor (or Reserve Bank President). These are: a deep respect for the Fed’s legal mandate; a clear understanding of an analytic framework that makes policy choices reasonably predictable and effective; and an open-mindedness combined with humility that tempers the application of that framework….

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Inflation risks and inflation expectations

U.S. inflation has been low and steady for three decades. This welcome stability is not merely a consequence of good fortune. Shocks that in the past might led to higher trend inflation—like the energy price increases—continue to buffet the economy much as they did in the 1970s and 1980s, when inflation rose to a peacetime record. Rather, it reflects the improved monetary policy of the Federal Reserve, which began acting as an inflation-targeting central bank in the mid-1980s, long before it announced a 2% target for inflation in 2012. As a consequence of the Fed’s sustained efforts, long-run inflation expectations have remained close to 2% for more than 20 years. One result is that temporary disturbances that drive inflation above or below target quickly fade.

This is the optimistic conclusion of the 2017 U.S. Monetary Policy Forum (USMPF) report. Since the adoption of the de facto inflation-targeting regime, one-off shocks have little impact on the inflation trend. Moreover, as many have observed, the relationship between unemployment and inflation—the Phillips curve (see our primer)—is now notably weaker. However, the authors of that earlier report warn that the Phillips curve “flattening” could be a direct consequence of the Fed’s success. Furthermore, since the sample period from 1984 to 2016 excludes any sustained period of a very tight economywide labor market, it would not be possible to detect an outsized impact, if any, of persistently low unemployment on inflation.

Enter the 2019 USMPF report, which focuses on the possibility that inflation may indeed respond differently when the unemployment rate is very low and projected to remain low for several years (see, for example the FOMC’s latest Summary of Economic Projections). The logic is straightforward: if labor is very scarce for an extended period, employers will bid up wages and (unless they are prepared to accept declining profits) pass on those cost increases in the form of higher prices….

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FOMC Communication: What a Long, Strange Trip It's Been

Following their January 2019 meeting, the Federal Open Market Committee (FOMC) came in for intense criticism. Instead of a truculent President complaining about tightening, this time it was financial market participants grumbling about a sudden accommodative shift. In December 2018, Fed policymakers’ suggested that, if the economy and market conditions evolved as expected, they probably would raise interest rates further in 2019. Faced with changes in the outlook, six weeks later they altered the message, suggesting that going forward, monetary easing and tightening were almost equally likely.

We find the resulting outcry difficult to fathom. The FOMC’s perceptions of the outlook may have been incorrect in December, in January, or both. There are myriad ways for economic and market forecasts to go wrong. But, to secure their long-run objectives of stable prices and maximum sustainable employment, isn’t it sometimes necessary for policymakers to change direction, and when they do, to explain why?

The point is that the recent turmoil arises at least in part from the Fed’s high level of transparency. In this post, we summarize the evolution of Federal Reserve communication policy over the past 30 years, and discuss the importance and likely impact of these changes. While transparency is far from a panacea, we conclude that the evolution has been useful for making policy more effective and sustainable, and remains critical for accountability and democratic legitimacy….

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Bad Precedent

Recent reports that President Trump wanted to fire Board Chairman Powell in response to Federal Reserve interest rate hikes are unprecedented. Denials from senior officials―Treasury Secretary Mnuchin and Council of Economic Advisers Chairman Hassett―have even less credibility than would a statement (or tweet) from the President himself. We find this entire discussion extremely disheartening and surely damaging to economic policy and the credibility of the Federal Reserve. As former Chair Yellen has stated, the risk is that people lose “confidence in the Fed, in the basis for its actions and its responsiveness to its mandate” (see here, time mark: 18:51).

To be sure, there is some debate over whether the President can fire the Fed Chair, other than “for cause.” We are not lawyers, but thoughtful people such as Peter Conti-Brown suggest that the answer is yes. Against this background, we view President Trump’s actions (and reported wishes) as the most serious threat to Fed independence since the Treasury-Fed accord of March 1951….

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What Should the Fed Own?

The Federal Reserve began to consider just how far its balance sheet consolidation should go well before the tapering actually began nearly a year ago. Earlier staff analyses pointed to a gradual runoff of long-term debt that could take years to reduce Fed assets to a new long-run equilibrium. More recently, market observers have speculated about an early end to consolidation that would result in a higher steady-state level.

Yet, as a recent Wall Street Journal article highlights, policymakers and analysts have devoted less attention to the mix of assets that the Fed should select once the balance sheet shrinks to its long-run equilibrium and policymakers allow it to expand slowly—say, in line with the increase of demand for currency.

In this post, we argue that the Fed should aim in normal times—when the economy is expanding and absent any financial strains—for a portfolio that has minimal liquidity, maturity and credit risk. In practical terms, this means that their portfolio should be composed largely of Treasury bills and short-term notes, with an average maturity that is very short….

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Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

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Trump v. Fed

Last month, interrupting decades of presidential self-restraint, President Trump openly criticized the Federal Reserve. Given the President’s penchant for dismissing valuable institutions, it is hard to be surprised. Perhaps more surprising is the high quality of his appointments to the Board of Governors. Against that background, the limited financial market reaction to the President’s comments suggests that investors are reasonably focused on the selection of qualified academics and individuals with valuable policy and business experience, rather than a few early-morning words of reproof.

Nevertheless, the President’s comments are seriously disturbing and—were they to become routine—risk undermining the significant benefits that Federal Reserve independence brings. Importantly, the criticism occurred despite sustained strength in the economy and financial markets, and despite the stimulative monetary and fiscal policies in place….

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Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

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Ensuring Stress Tests Remain Effective

Last month, the Federal Reserve Board published proposed refinements to its annual Comprehensive Capital Analysis and Review (CCAR) exercise—the supervisory stress test that evaluates the capital adequacy of the largest U.S. banks (34 in the 2017 test). In our view, the Federal Reserve has an effective framework for carrying out these all-important stress tests. Having started in 2011, the Fed is now embarking on only the seventh CCAR exercise. That means that everyone is still learning how to best structure and execute the tests. The December proposals are clearly in this spirit.

With this same goal in mind, we make the following proposals for enhancing the stress tests and preserving their effectiveness:

---  Change the scenarios more aggressively and unexpectedly, continuing to disclose them only after banks’ exposures are fixed.
---  Introduce an experimental scenario (that will not be used in “grading” the bank’s relative performance or capital plans) to assess the implications of events outside of historical experience and to probe for weaknesses in the system.
---  As a way to evaluate banks’ internal models, require publication of loss rates or risk-weighted assets for the same hypothetical portfolios for which the Fed is disclosing its estimates.
---  Stick with the annual CCAR cycle....

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Why the central bank should be a leading supervisor

Should central banks be a leading supervisor, including supervising systemically important institutions? This is a question that members of the U.S. Congress periodically raise.  Our answer is unequivocally yes. As the lender of last resort, as the monetary policy authority, and as the organization responsible for overseeing the health and stability of the overall financial system—what we could call a systemic regulator—the central bank needs to be a leading supervisor....

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Regulatory Discretion and Asset Prices

The Federal Reserve’s annual stress test is the de facto capital planning regime for the largest U.S. banks. Not surprisingly, it comes under frequent attack from bank CEOs who argue, as Jamie Dimon recently did, that “banks have too much capital…and more of that capital can be safely used to finance the economy” (see page 22 here). From their perspective, this makes sense. Bank shareholders, who the CEOs represent, benefit from the upside in good times, but do not bear the full costs when the financial system falters. As readers of this blog know, we’ve argued frequently that capital requirements should be raised further in order to better align banks’ private incentives with those of society (see, for example, here and here).

A more compelling criticism of central bank stress tests focuses on their discretionary character. To the extent feasible, central banks should minimize their interference in the allocation of resources by private intermediaries, allowing them to direct lending to those projects deemed to be the most productive.

But the painful lessons that have come from large asset price swings and high concentrations of risk provide a strong case for the kind of limited discretion that the Fed uses in formulating its stress tests. This blog post highlights why it makes sense for regulators to use this year's stress test exercise to learn how well the largest U.S. intermediaries would fare if the recent commercial real estate price boom were to turn into a bust....

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The Fed's Balance Sheet and the Stance of Monetary Policy

U.S. monetary policy is tightening, as everyone who pays even the slightest attention to the financial news knows. But when and how?  Here, the discussion is focused on two complementary aspects of Federal Reserve policy: interest rates and the balance sheet. The first of these concerns policy of the old-style conventional type. The second is about the consequences of quantitative easing. At $4.23 trillion, more than 5 times the 2007 level, the size of securities holdings raises a series of questions: When will the Federal Reserve’s Open Market Committee (FOMC) start to shrink its balance sheet?  How will they do it? How far will they go?  And, most importantly, what will be the consequences for the stance of monetary policy?

On the first two―when and how―the minutes of the March 14-15, 2017 FOMC meeting provide the answers: later this year, the FOMC expects to instruct the open market operations staff at the New York Fed to stop reinvesting the proceeds from maturing securities. Consistent with the policy normalization principles published in September 2014, there is no hint that they will actively sell securities.

The key uncertainty is how far they will go. At this stage, there is little indication of a consensus on how big or small the balance sheet should be at the end of the process. Even if this uncertainty is clarified, however, any additional impact from balance sheet policy on the stance of policy probably will be limited....

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An Open Letter to Congressman Patrick McHenry

Dear Vice Chair McHenry,

We find your January 31 letter to Federal Reserve Board Chair Janet Yellen both misleading and misguided.

It is in the best interest of U.S. citizens and our financial system that the Federal Reserve (and all the other U.S. regulators) continue to participate actively in international financial-standard-setting bodies. The Congress has many opportunities to hold the Fed accountable for its regulatory actions, which are very transparent. We hope that the new U.S. Administration will support the Fed’s efforts to promote a safe and efficient global financial system.

Your letter is filled with false assumptions and assertions....

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Ending Too Big to Fail

More than six years after the Dodd-Frank Act passed in July 2010, the controversy over how to end “too big to fail” (TBTF) remains a key focus of financial reform. Indeed, TBTF—which led to the troubling bailouts of financial behemoths in the crisis of 2007-2009—is still one of the biggest challenges in reducing the probability and severity of financial crises. By focusing on the largest, most complex, most interconnected financial intermediaries, Dodd-Frank gave officials a range of crisis prevention and management tools. These include the power to designate specific institutions as systemically important financial institutions (SIFIs), a broadening of Fed supervision, the authority to impose stress tests and living wills, and (with the FDIC’s “Orderly Liquidation Authority”) the ability to facilitate the resolution of a troubled SIFI. But, while Dodd-Frank has likely made the U.S. financial system safer than it was, it does not go far enough in reducing the risk of financial crises or in ensuring credibility of the resolution mechanism (see our earlier commentary here, here and here). It also is exceedingly complex.

Against this background, we welcome the work of the Federal Reserve Bank of Minneapolis and their recently announced Minneapolis Plan to End Too Big to Fail (the Plan). While the Plan raises issues that require further consideration—including the potential for regulatory arbitrage and the calibration of the tools on which it relies—it is straightforward, based on sound principles, and focuses on cost-effective tools. In this sense, the Plan represents a big step forward...

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Transparent stress tests?

This month, the Committee on Capital Market Regulation (CCMR) published a paper criticizing the procedures the Federal Reserve uses in conducting its stress tests. The claim is that, in its annual Comprehensive Capital Analysis and Review (CCAR), the Fed is violating the Administrative Procedures Act of 1946 (APA). The CCMR’s proposed solution is more transparency. As big fans of both stress tests and transparency in general, and of the CCAR in particular, we find this legal challenge very troubling.

We believe that making the stress tests more transparent in the ways that the CCMR suggests would make them much less effective. This would do serious damage to financial stability policy and (ultimately) increase the likelihood of another crisis... 

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The FOMC's Prudent Caution

Imagine Fed Governor Rip van Winkle waking from a 10-year nap to find that trend inflation is only a bit shy of the 2% target, the unemployment rate is close to its long-run steady state, and the Fed’s balance sheet is five times larger than when he fell asleep. As we wrote two years ago, you could forgive him for expecting the federal funds rate to be closer to 4% than ½%. And, you would understand his astonishment when he learns that financial market expectations of policy tightening have collapsed amid continued economic expansion.

So, why are both the current policy rate and expectations of the future rate so low? There are four powerful reasons. First, both investors and policymakers have lowered their estimates of the steady-state (or “natural”) real interest rate. That means that Fed policy today is less accommodative than Governor Rip’s 10-year-old perspective leads him to think. Second, Rip is surely startled to learn that, even with a tightening labor market and policy rates close to zero, market-based long-run inflation expectations have declined. Third, it seems unlikely that Rip would be thinking much about the policy asymmetry that occurs when the nominal interest rate is near the effective lower bound. That is, as post-crisis experience suggests, with policy rates near (or even below) zero, it is much easier for central banks to tighten when prices rise too quickly than it is to ease should prices start to fall. Fourth, the economy’s productive capacity may be endogenous: that is, it may be possible for trend growth to be higher than recent experience suggests...

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