Nontraditional Monetary Policy and the Economic Outlook*
Remarks by Charles L. Evans
President and Chief Executive Officer
Federal Reserve Bank of Chicago
Chamber of Commerce of St. Joseph County
South Bend, IN
Good afternoon and thank you, Mark [(Dobson), president and CEO of the Chamber] for that introduction. And thanks to the Chamber of Commerce of St. Joseph County for inviting me this afternoon to share my thoughts on nontraditional monetary policies and the economic outlook.
Following the worst financial crisis of the past 70 years, we are currently experiencing a recession that will likely match or surpass those of the 1970s and 1980s in depth and severity. Much like the rest of Indiana and surrounding states, the South Bend—Mishawaka area has been hit hard by the national recession.
While the area's outsized education and health services sectors have buffered overall job loss to some extent, this buffer has been undone by the region's outsized concentration in manufacturing and distribution.
These exceptional circumstances have posed great challenges for both the economy and policymakers. For us at the Fed, the response has been to pursue a variety of aggressive and innovative approaches that differ significantly from the standard policies of the past. The programs we have put in place are designed specifically for these exceptional circumstances. As such, they will have to be unwound as our financial system returns to normal and the economy is more clearly headed toward sustainable growth and price stability. Today I would like to discuss the precepts that underlie these nontraditional policies, provide my outlook for the economy, and conclude with thoughts on some of the tactical issues we must consider when unwinding the programs. I should note that these are my own views and not necessarily those of my colleagues in the Federal Reserve System.
In the current crisis, traditional monetary policy has reached its limits in two ways. One obvious way is that the federal funds target rate, which is the Fed's traditional policy instrument, has been lowered to essentially zero. This target cannot be reduced below zero even when further accommodation is warranted. The second limit of traditional policy has to do with the functioning of financial markets. Under normal circumstances, participants seeking profit opportunities tend to align risk-adjusted returns across all markets. This allows a change in the federal funds rate to flow through to other interest rates across the entire range of maturity and risk structures. But during the crisis, disparities in rates across markets have indicated that arbitrage was not taking place as usual. Thus, even before our target was constrained by zero, we found that we could not affect the interest rates that matter to consumers and businesses to stimulate aggregate demand as much as was necessary.
Because of these limitations, the Fed has turned to nontraditional monetary policies. These can be broadly categorized in three groups. The first group expands on something that has always been a part of our policy toolkit, namely, discount window lending through which the Federal Reserve Banks make short-term loans to depository institutions against adequate collateral. Since August 2007, the Fed has taken steps to encourage the use of the discount window as a source of liquidity, including reducing the discount rate and lengthening the terms of the loans. The second group of policies consists of opening new lending facilities to a wide array of participants in financial markets. One can think of it as a sort of discount window for financial participants that are not depository institutions. The third group of policies consists of large-scale purchases of government-sponsored enterprise (GSE) debt, mortgage-backed securities (MBS), and Treasury securities. This can be seen as an extension of traditional open-market operations. The Fed still exchanges reserves for bonds, but on a vastly different scale.
Taken as a whole, our nontraditional monetary policies might look like a vast array of acronyms—the famous "alphabet soup" (TSLF, PDCF, etc.). But there is a method to the madness, and I will highlight three precepts that guide our thinking. The first is insurance: Don't put all your eggs in one acronym. The second is innovation: This is not your grandfather's Fed. And the third is size: In an environment of great uncertainty, as we like to say in Chicago, "make no little plans." I will discuss each of these precepts before addressing some tactical issues we must consider in unwinding the programs and returning to more traditional policies.
To understand the first precept, we have to remember the diversity of risks and related uncertainties that emerged in the past two years and the speed at which they transpired. Each risk was a challenge to our mandate of fostering a sound financial system, stable growth, and price stability. We saw failures in parts of the financial system, but did not know how serious they were and how they would affect the rest of the economy. We also saw economic activity begin to deteriorate significantly, but were uncertain how deep the downturn would be. Finally, price levels declined for the first time in decades, but we did not know if we would slide into an extended period of deflation.
The diagnosis of our problems was surrounded with much uncertainty and included some dire scenarios. But the remedies that we considered brought their own measure of uncertainty as well. By definition, we had little experience with these new policies and were unsure how effective they would be and which could be implemented in a timely fashion given the practical and legal constraints we were facing.
The Fed decided to adopt an approach that would be robust to these multiple dimensions of uncertainty. Rather than rely on any single tool lest it prove inadequate, we have put in place a number of different remedies in quick succession, in the hope that we may learn which ones work best without losing valuable time.
I won't retrace the complete list of new programs, as these have been covered extensively in other speeches. But I will discuss one program because it demonstrates our second precept, which is the need to innovate as quickly as circumstances change. Let's look at the Term Asset-Backed Securities Loan Facility, or TALF.
After the failure of Lehman Brothers, the markets for asset-backed securities (ABS) effectively shut down in October 2008. The ABS markets play a vital role in providing funds that support loans to consumers and small businesses. In response the Fed announced the formation of TALF in November 2008. With backing from the Treasury, TALF is aimed at revitalizing the ABS markets by providing loans to investors to finance their purchases of certain highly rated asset-backed securities, with the securities themselves as collateral for the loans.
The first markets targeted by the facility were relatively simple assets—auto, student, credit card, and Small Business Administration (SBA) loans. These securities were familiar to market participants, and their pricing was relatively straightforward. Since then we have moved on to more complex and long-lived instruments, including legacy assets.
TALF has generated two opposite concerns: One is that our credit requirements are too conservative and unlikely to fund large volumes; the other is that the central bank is taking too much credit risk on its balance sheet. I think we have struck a good balance between these concerns. We have taken appropriate action to limit our exposure to credit risk through stringent credit quality requirements on the assets, substantial haircuts, and the direct support of the Treasury. Importantly, TALF is not intended to substitute for the ABS markets as they existed before the crisis, nor is it intended to revive them to their former level of activity solely on the back of the Federal Reserve System. The goal is to boost private sector credit flows in support of the economy by mitigating some of the stresses in these markets. In turn, this should allow the markets to reach their appropriate size in a less disruptive fashion. At this point we see evidence that TALF is working as intended. Spreads on asset-backed securities have come down. And while much of the recent ABS issuance has been supported by TALF loans, some institutional investors are re-entering these markets without that support.
The third precept relates to size. Until recently, monetary policy tended to change in small steps, a behavior that some have labeled "policy gradualism." Our response to the present crisis has moved beyond gradualism. Our rapid January 2008 cuts in the federal funds rate were one indication, and the size of our nontraditional policies is another.
Notably, in March we announced a considerable increase in our large-scale asset purchase program, in which we buy GSE agency debt and MBS and long-term Treasury notes. We made this aggressive move to substantially increase monetary accommodation in light of the considerable risks that the real economy faced at that time. As a consequence, however, there was another large increase in the size of our balance sheet, and it is now well above what it has typically been.
We moved swiftly to launch nontraditional policies, but some of them have taken time to implement because their proper design required great care. And just as traditional policy is well known to act with long lags, nontraditional policies also take time to affect economic activity. Weak economic news by itself would not imply that we have misjudged the size of our latest actions. In my view, it would take a significant deterioration relative to our outlook for me to view our current policies as inadequate.
Turning now to the economic outlook, the U.S. economy has contracted sharply since the middle of last year, with real gross domestic product (GDP) having dropped at an average annual rate of about 4.1 percent from the third quarter of 2008 to the first quarter of this year. Employment has fallen by more than 5-1/2 million since then. The downturn in activity has been widespread across the economy, with significant declines in consumer spending, residential investment, and business investment.
However, there have been some favorable developments of late, and the possibility that the economy is closer to a turning point is stronger now than just three months ago. Although the data have been uneven, our reading of the recent indicators is that the pace of contraction is slowing and that activity is bottoming out. We expect modest increases in output in the second half of this year followed by somewhat stronger growth in 2010.
So what are these signs of improvement that underlie this forecast? First, financial market conditions have improved, with credit spreads and other measures of market stress much lower than they were in late 2008 and early 2009.
Consumer spending, which had dropped sharply since the second half of last year, has been roughly flat so far in 2009. Housing markets, after more than three years of decline, have also shown some signs of stabilizing. Sales of both new and existing homes have appeared to flatten out in recent months, though both remain at very low levels. Meanwhile, homebuilders have reduced their backlog of unsold new homes—a precondition for any recovery in homebuilding. But the backlog of unsold existing homes remains high, and delinquency and foreclosure rates continue to be a substantial risk to the housing market recovery.
Labor markets remain weak, but there has been a (somewhat uneven) decline in the pace of job losses. The May and June average of monthly declines in employment was about half the rate of contraction as the beginning of this year, and newly filed jobless claims seem to have peaked in late March. However, firms are still reluctant to hire, and the unemployment rate reached 9-1/2 percent in June and will likely further increase through the remainder of the year before it flattens out in 2010.
The industrial side of the economy has been especially hard hit this year, but there are signs that the worst of the decline in the sector is in the past. Business fixed investment remains weak, but the decline is getting shallower. Steep inventory liquidations made significant negative contributions to output growth in late 2008 and early 2009. But this means that inventories are in better alignment with sales, so we expect to see less dramatic liquidation in the months ahead. In turn, the smaller declines translate into a net positive for GDP growth. Finally, in the coming months, the fiscal stimulus will continue to have positive influences on the economy.
Forecasting inflation is never easy, but these are particularly difficult times for this exercise. All one has to do is look at the remarkable lack of consensus among professional forecasters. The spread between the lowest and the highest inflation forecast for 2010 reported by Blue Chip Economic Indicators is more than twice what it was a year ago for inflation in 2009. Two conflicting forces could come into play to explain such a wide range of opinions. A high unemployment rate and low rates of capacity usage, such as we now have, normally place strong downward pressure on costs and tend to lower inflation. Indeed, some statistical models have pointed to possible deflation risks in the quarters ahead. But inflation has not fallen to the extent we might have feared; and there is another factor that could come into play, namely, consumers' and businesses' expectations of future inflation. So far, expectations as measured by surveys have remained relatively stable, which is a bit of a surprise considering that the severity of the downturn might have worked to lower them. And as economic conditions improve, consumers and businesses might expect upward pressure on inflation; and experience shows that a rise in inflation expectations, once solidified, becomes embedded in many economic decisions and makes inflation harder to control.
Currently, core inflation is near 2 percent, a level I generally find acceptable. In the near term, I think the downward forces on inflation will be greater than the upward forces, and we could see some declines in core inflation. But over the medium term I see the risks to the inflation forecast as being more balanced.
Back to normal
Over time, as the economy is more clearly headed toward sustainable growth and stable prices, the challenge for the Fed will be the unwinding of our nontraditional programs. As this happens, the Fed will progressively return to its traditional policies—that is, setting the federal funds rate—and will reduce its balance sheet in an orderly way.
How will it do so? Partly on its own. Many of our liquidity programs provide short-term loans, so as these programs come to an end, the loans will mature fairly quickly and our balance sheet will shrink. Also, the pricing of our programs is designed to be unattractive in normal times. As they cease to be useful, they will cease to be used. Indeed, some programs are already being used less, and we should see that trend continue as conditions in financial markets improve further.
Nonetheless, a significant portion of our balance sheet may not shrink on its own or at the appropriate rate. We need tools to manage it actively so that monetary policy can be more easily recalibrated. In this respect, we can be as creative on the way out as we were on the way in; or, put another way, we can be creative with our liabilities the way we have been creative with our assets.
One way to manage our balance sheet is to sell the assets. They can be sold outright, or they can be leased through reverse repurchase transactions. Another tool is the payment of interest on reserves, which we began last fall. Without interest on reserves, rates are raised only by restraining the quantity of reserves available to the market, and reaching our target could require sharp reductions in our balance sheet. With interest on reserves, we can raise the interest paid on reserves in tandem with our target rate. This will raise the opportunity cost of banks' lending and keep the federal funds rate near the target.
What circumstances might require us to use the tools we have, and those we may have in the future, to reduce our balance sheet aggressively? One clear concern is price stability. Our balance sheet grew very fast and remains large. There are historical precedents for large increases in central bank balance sheets to result in broader credit expansion and to be subsequently associated with inflation. But I want to emphasize the middle link in this chain: Inflationary pressures will not arise without broader credit expansion, and there is no evidence for that at present.
Nevertheless, these precedents explain why there is concern on this point and why we look after our ability to reverse the growth in our balance sheet.
Right now, in the absence of unexpected shocks and changes, I don't foresee the need for any major changes to the policy parameters of the programs, and I view us in a wait and see mode.
These have been challenging times, and the Fed has met the challenge with an array of innovative programs that depart from traditional policy. We have pursued this approach in a manner that is both commensurate to the size and robust to the variety of risks we have faced. The multiplicity of programs should not obscure the fact that, although the means are many, the ends remain unchanged. Both traditional and nontraditional policies are aimed at fostering a stable financial system, sustainable growth, and price stability. As economic conditions continue to improve and we lay the groundwork for an orderly reduction in our balance sheet, these ends remain uppermost in our minds.
*The views presented here are my own, and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.