The Origins of Unconventional Monetary Policy in the U.S.

The Great Recession, dating from late 2007 to mid-2009, is generally understood as originating from severe disruption in the financial sector. Incentive problems in the mortgage market, created primarily by defects in the U.S. financial regulatory structure, led to the global financial crisis in late 2007 through early 2009. The crisis manifested itself in a collapse in the prices of U.S. real estate, which led to mortgage defaults and dysfunction in the financial markets that were closely tied to those mortgages. These markets were principally in mortgage-backed securities (MBS), which used those securities as collateral, and in derivatives. Financial distress spread through tightly connected worldwide financial markets, culminating in the failure of Lehman Brothers and the near-collapse of other large U.S. financial institutions in the latter half of 2008.

As early as the late 19th century, there was a good understanding of crisis intervention by central banks to prevent or mitigate financial panic through central bank lending; this was well-articulated in the work of Walter Bagehot in 1873 in Lombard Street.¹ Nevertheless, the Fed appeared to forget these lessons during the Great Depression, which started in 1929. As has been frequently argued (for example, by economists Milton Friedman and Anna Schwartz in a book in 1963), the Fed did not use its lending powers wisely during that period, especially in the 1933 banking crisis.

With the onset of the latest financial crisis, the Fed did not want to repeat the errors of the Great Depression; so, it responded aggressively in terms of lending to commercial banks and other financial institutions. Figure 1 shows total lending, which increased somewhat in the spring of 2008 before a substantial spike in the fall of 2008. Then, lending declined sharply so that, at the end of the Great Recession (the wider shaded area in the chart), total lending was about one-half what it was at its peak in the fall of 2008. By the beginning of 2013, lending had tapered off, reaching pre-Great Recession levels.

In addition to crisis lending, the Fed resorted to the use of conventional interest rate policy in response to the financial crisis. The Fed’s target for the overnight fed funds rate was cut beginning in late 2007 and ultimately reached near-zero levels by the end of 2008, when the fed funds rate was targeted at a range of 0 to 0.25 percent. (See Figure 2.)

By the end of the Great Recession in mid-2009, the financial crisis had passed and so had much of the Fed’s emergency lending programs. (See Figure 1.) But the 2007-2009 recession had been quite deep, so the Fed’s interest rate policy was still on emergency setting, with the fed funds rate target remaining at 0 to 0.25 percent. As well, the Fed had begun experiments with two unconventional policy tools—forward guidance and quantitative easing.²

Forward guidance consists of promises made by the central bank concerning its future actions. Generally, modern macroeconomic theory makes a convincing case that monetary policy works more effectively when the central bank behaves systematically so that policy is well-understood by the public. This is certainly part of what forward guidance is about. If forward guidance is to work, the public must believe that the Fed’s statements about the future are not just cheap talk—the Fed’s promises must be credible.

But there is more to forward guidance than that. In New Keynesian theory—as explained, for example, by economist Michael Woodford—the Fed has some policy leverage even when the nominal interest rate is at zero and can go no lower.³ Why? According to the theory, the Fed can make a promise to keep interest rates lower in the future than it otherwise would, and such a promise, if credible, will cause people to believe that inflation will be high in the future, causing them to borrow more and spend more today. Thus, New Keynesian theory recommends forward guidance as a means for the central bank to stimulate the economy by promising to be irresponsible in the future.

As of the end of the Great Recession, the Fed’s forward guidance consisted of the following promise:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.⁴

Such a promise seems consistent with Woodford’s New Keynesian ideas about the role of forward guidance.

Quantitative easing (QE) is a central bank policy involving purchases of unconventional assets with somewhat unconventional goals in mind. Asset purchases are a conventional tool for monetary policy and have formed the cornerstone of Fed policy in normal times, at least since the founding of the FOMC in 1933. The Fed typically uses daily open market operations—the purchases and sales of short-term government securities (for example, a typical short-term government security is a 3-month Treasury bill, which matures three months from the date of issue)—to hit the overnight fed funds interest rate target set by the FOMC. Quantitative easing, which has typically been carried out when overnight interest rates are at or close to zero, involves the purchase of long-term assets (for example, 30-year Treasury bonds, which mature 30 years from the date of issue), and those assets need not be government-issued securities. The goal of quantitative easing is to lower the interest rates on long-term assets, rather than to lower short-term interest rates as with conventional easing. If quantitative easing works, it should reduce all long-term interest rates, including mortgage interest rates, for example.

The Fed began its first quantitative easing program, sometimes called QE1, in November 2008, before the end of the Great Recession. QE1 involved the purchase of long-term Treasury securities, agency securities and mortgage-backed securities. MBS are tradeable securities, backed by underlying private mortgages.

The recovery from the Great Recession proved to be unusually slow. Figure 3 shows a comparison of the recoveries following the 1981-82 recession—one of the more severe recessions in the post-World War II period in the U.S.—and the Great Recession of 2007-09. The figure shows real GDP in each recession, scaled to 100 as of the beginning of the recession. As can be seen in the figure, it took about twice as long in the Great Recession for real GDP to attain its previous peak compared with real GDP performance in the recovery after the 1981-82 recession. Further, after more than seven years (30 quarters in the figure), the 1981-82 recovery was about 20 percent more advanced than was the recovery from the Great Recession.

The relatively weak recovery, in the face of interest rates that had been unusually low and after some unconventional policies had already been put into effect, spurred the Fed to engage in further accommodation. Because the range for the fed funds rate was already 0-0.25 percent, there were no remaining accommodative options other than unconventional monetary policies. In terms of forward guidance, the language in the FOMC’s policy statements (released after each FOMC meeting) evolved over time, from the “extended period” language mentioned earlier, to promises to keep the fed funds rate in the 0-0.25 percent range at least until some calendar date in the future, to promises to keep the fed funds rate low at least until the unemployment rate had fallen below a 6.5 percent threshold (so long as projected inflation did not rise above 2.5 percent). In anticipation of crossing the unemployment rate threshold, in March 2014 the FOMC promised to keep the fed funds rate low for a “considerable time.”⁵ As shown in Figure 2, the fed funds rate was close to zero for seven years, a zero-interest-rate policy (ZIRP) that was unprecedented in the modern period of U.S. monetary policy, which began in 1951.⁶

The Fed also continued with its QE policies after the Great Recession’s official end, which was in June 2009. The QE1 program continued until March 2010. Then, in August 2010, the FOMC instituted a reinvestment program, which served to replace long-term assets in the Fed’s portfolio as they matured. Any increase in the Fed’s balance sheet through asset purchases ultimately is removed when the purchased assets mature; so, the reinvestment policy acted to keep the QE policy from undoing itself naturally. The reinvestment policy remains in effect today.

From November 2010 to June 2011, the Fed executed QE2—the purchase of $600 billion in long-term Treasury securities. This was followed by the “twist” program, from September 2011 to December 2012, under which the Fed sold short-term assets and purchased long-term assets, thus further lengthening the average maturity of the assets on its balance sheet. Finally, from September 2012 to October 2014, the Fed ran its QE3 program: a large-scale purchase of mortgage-backed securities and long-term Treasury securities.

Figure 4 shows total securities held by the Fed, which increased by more than fivefold from before the Great Recession until now. Note the large increases in the quantity of securities that correspond to QE1, QE2 and QE3. What is not reflected in the figure is the increase in the average maturity of the Fed’s portfolio. For example, at the end of 2007, about one-third of the Fed’s securities were in the form of short-term Treasury bills, but the Fed now holds none of those assets.

The large quantity of assets purchased by the Fed since 2008 had to be financed, of course, by an increase in the Fed’s liabilities. Figure 5 shows the stocks of currency in circulation, reserves held by financial institutions and reverse repurchase agreements (reverse repos), which in total comprise essentially all Fed liabilities. The stock of currency has grown relatively smoothly since before the financial crisis, with a moderate increase during the crisis because of an increased appetite for safe U.S. currency in the world. But most of the increase in the Fed’s assets was reflected in a large increase in the stock of reserves. Before the financial crisis, in 2007, reserve balances were typically in the range of $5 billion to $10 billion, while the Jan. 27, 2016, level was about $2.4 trillion. From late 2008 to December 2015, reserves bore interest, albeit at a low interest rate of 0.25 percent. This interest rate was increased to 0.5 percent on Dec. 17, 2015, and is expected to continue to rise (probably at a slow rate) in the future. Interest-bearing liabilities of the Fed also now include a substantial quantity of reverse repurchase agreements, which play a similar role to reserves, with some very important qualifications. Reverse repos will be discussed in more detail later in this article.

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Some History of Unconventional Monetary Policy

Unconventional monetary policy, in practice, has taken two primary forms: forward guidance and quantitative easing (QE). With respect to forward guidance, macroeconomists have understood, at least since the revolution in macroeconomics that took place in the 1970s, that monetary policy works better if it is predictable and if the public believes what central bankers say. Forward guidance assigns an important role not only to what a central bank is doing in the present but to what central bankers say about what they are going to do in the future.

Paul Volcker*

A historical example of forward guidance at work occurred during Paul Volcker’s term as Fed chairman, from 1979 to 1987. Volcker determined early in his term that the inflation rate was too high in the United States. He clearly announced his intentions to reduce inflation and specified how the Fed would do it. Although the disinflation that occurred in the early 1980s was costly—there was a severe recession in 1981-82—the costs were temporary. Indeed, a widely held concern before the disinflation was that high inflation expectations were so well-entrenched that disinflation would take much longer than what actually transpired. Part of the credit for the shortness of the disinflationary period was that Volcker’s statements were credible: People believed that he would actually do what he claimed he would do, and inflation expectations fell quickly as a result.

Though forward guidance has been an important part of the Fed’s policy framework for a long time, it became increasingly important during and after the financial crisis. As evidence of this, for example, the FOMC’s statement of Feb. 2, 2005 (when Alan Greenspan was Fed chairman), was 262 words long, the statement of Jan. 27, 2010, was 547 words, and the statement of Dec. 16, 2015, was 596 words. Clearly, the FOMC increasingly had much more to say, and the added words were primarily related to forward guidance.

The second element of unconventional monetary policy—of key importance in the United States after the financial crisis—is QE, which was first discussed and implemented in 2001 by the Bank of Japan. This early experiment could probably be more appropriately categorized as conventional monetary policy, rather than unconventional policy. In 2001, Japan had been following ZIRP (zero-interest-rate policy) for about six years and was experiencing a deflation—consumer prices were falling. The Bank of Japan engaged at that time in purchases of large quantities of short-term government securities in an attempt to increase inflation, but to no avail as the deflation continued.⁷ What the Bank of Japan had discovered was the liquidity trap—with ZIRP in place, an open market purchase of short-term government debt by the central bank should have no effect because zero-interest bank reserves are replacing zero-interest government debt in financial markets.

QE, if it is to have the potential to work, must involve purchases by the central bank of unconventional assets—either long-term government debt (instead of short-term) or assets that are not liabilities of the government. After the financial crisis, some central banks started conducting genuine QE in earnest. The Fed made large purchases of long-term government debt and mortgage-backed securities, the Bank of England had a large QE program, Switzerland had a very large QE program and the European Central Bank is still engaged in an active QE program.

Glossary

Walter Bagehot**

Bagehot, Walter: a British journalist who often wrote about economics in the mid-1800s. Perhaps most notable among his books was Lombard Street: A Description of the Money Market, in which he explained the worlds of banking and finance. Some of his ideas found their way into the Federal Reserve Act of 1913. For example, the Federal Reserve System was initially envisioned in the act as a means for the regional Federal Reserve banks to lend to banks in their districts, both in normal times and in emergencies. [ back to text ]

Liquidity trap: a situation in which an open market purchase of short-term government securities by the central bank increases the money supply but has no effect on market interest rates or any other economic variables. [ back to text ]

Mortgage-backed security (MBS): a tradeable security backed by a bundle of private mortgages. [ back to text ]

New Keynesianism: a synthesis of ideas from John Maynard Keynes (Old Keynesianism) and the post-1970 revolution in macroeconomics. In New Keynesian theory, the Phillips curve (a negative relationship between inflation and unemployment) is important. [ back to text ]

Open market operations: the purchase (sale) of U.S. government securities, generally Treasury securities, from (to) financial institutions on the open market in order to increase (decrease) total reserves, therefore lowering (raising) the federal funds rate by influencing the supply of reserves available to be lent; these transactions serve as a way to effectively control the federal funds rate in a channel system. [ back to text ]

Reverse repurchase agreement (RRP): the borrowing of funds by a central bank from a financial institution, generally overnight (ON-RRP), with central bank-owned securities held by the financial institution as collateral until the funds are returned; this monetary policy tool serves as a way to expand the set of institutions that can hold interest-bearing Federal Reserve liabilities. The ON-RRP rate serves as a subfloor under the IOER (see next page) in the U.S. floor system. Often referred to as reverse repos. [ back to text ]

Zero-interest-rate policy (ZIRP): a monetary policy in which the central bank’s key interest rate is held near zero; this policy represents the limit of conventional monetary policy because, once such a policy is enacted, open market operations cannot lower overnight interest rates. [ back to text ]

Endnotes

1. See Bagehot on the References page at the end of the essay. [ back to text ]
2. Unconventional monetary policies are discussed in more detail in Williamson, 2014. [back to text]
3. See Woodford’s 2012 work. [ back to text ]
4. See the June 2009 FOMC statement. [ back to text ]
5. See March 2014 FOMC statement. [ back to text ]
6. 1951 marks the accord between the U.S. Treasury and the Fed that set up the modern institutional framework for monetary policy in the United States. [ back to text ]
7. The Bank of Japan did increase long-term government bond purchases, but the size of the increase was quite small in comparison to more recent QE programs. [ back to text ]

*Photo: Board of Governors of the Federal Reserve
**Photo: © Getty Images / Hulton Archive / Stringer