Monetary Policy Normalization: Introduction
Cletus Coughlin, senior vice president and chief of staff to St. Louis Fed President James Bullard, introduced the Dialogue with the Fed presentation, "Monetary Policy Normalization: What’s New? What’s Old? How Does It Matter?" He discussed how changes in the federal funds rate can impact other interest rates, which in turn affect other economic decisions. He also discussed some of the monetary policy actions taken by the Fed in order to stimulate the economy during the financial crisis and its aftermath.
- Part 1: Introduction
- Part 2: The Bank of England
- Part 3: Why the Fed Was Founded
- Part 4: The Tools of the Fed
- Part 5: Monetary Policy around the Great Recession
- Part 6: Normalization of Monetary Policy
- Part 7: Audience Q and A
Cletus Coughlin: Tonight, we're going to focus on monetary policy issues, and in particular, you can see from the title, we're going to talk about what we call monetary policy normalization. What's new, what's old, and how does it matter. And so what I'm going to do is spend just a couple minutes talking about where we're at, in terms of monetary policy. What we've done. And a little bit of the thinking. Steve's going to do most of the heavy lifting, in terms of discussing this issue. But I'd like to at least set the stage for what we're going to do tonight.
So during the financial crisis, and its aftermath, the Fed took a number of policy actions that ultimately were labeled as unconventional. One action affected what we call the federal funds rate target, okay? And the federal funds rate is an interest rate. And it's an interest rate at which, what we call banks or depository institutions, borrow from each other. That these financial institutions have deposits at the Fed. And at particular times, they have more. They're willing to lend their deposits to other institutions that need deposits. And so the rate at which they trade with each other, these so-called federal funds, is an interest rate that, in essence, the Fed can control. And Steve will talk a little bit more about how exactly we control that interest rate.
Now, while far from being in lockstep, our ability to control that interest rate has impacts on other interest rates. It's not one for one, and at times it doesn't exactly work nice and neat. But by lowering interest rates, we can have some impact on a wide variety of interest rates. Certainly shorter term interest rates. But potentially longer term interest rates, as well. Okay? So those interest rates, of course, affect economic decisions with respect to spending decisions on investment, and consumption. In other words, the interest rate that you might have to pay to buy a car, or buy a house or something like that. Those are important—that's an important price that influences your ability to purchase that automobile, or purchase that house, or any number of other types of goods and services as well. And so by influencing that interest rate, the hope is that we influence spending and economic activity so that we affect things like GDP and employment, and a whole bunch of other things. Okay?
So let me go through just a couple monetary policy slides to give you a perspective as to what's been going on. Okay? This is the federal funds rate that I was talking about before. Now, it's a little bit hard to see, but this lightly shaded area is the period of our most recent recession. Okay? In other words, that recession started in very late 2007 and was declared officially over—even though many people might not think so—in the middle of 2009. Okay? So what happened is that prior to the recession, back here in early 2007, we had a federal funds rate—effectively, the target—was five and a quarter. Okay? 5.25 was the percentage interest rate. And you can see how we—during the recession, in order to fight the recession, as well as for other reasons, we lowered that rate. And in fact, we lowered it quite dramatically. And we lowered it to effectively zero. Okay? And that's called the lower bound. That nominal interest rate generally can't get any lower than that. That we're effectively at zero. And it stayed that way, so far, for the next six and a half years, to date. And so people are beginning to wonder, "Well, this normalization, part of that normalization would lead to some type of increase or liftoff, if you will, of that particular interest rate." And so that's one of the things that our speaker tonight is going to talk about. Okay?
Along with this lowering of the federal funds rate, there was a great deal of discussion about attempting to provide what's called forward guidance. In other words, an expectation that the Fed communicated that we were going to keep rates low for an extended period of time, whatever that means. Okay? But the idea was to give a signal to the market that we weren't going raise rates any time soon. Okay? That's no longer the signal we're giving. But for a long time, that was an attempt to basically manage peoples' expectations concerning what monetary policy was going to do, as we went forward. Okay? Now, once you get to the lower bound, can you do anything else? Okay? And well, this gives you an idea of the Fed's balance sheet. Okay? That once again, the shaded area is the recession period, and that leading up into that recession, basically the amount of total assets on the books of the Fed was a little bit under $900 billion. Okay? The vast majority of these were U.S. Treasury securities that we owned, that we had purchased. Okay?
Now, you can see that through what's called QE 1, 2, and 3, that we began to ratchet up the size of the U.S. balance sheet. In other words, we purchased a whole bunch of U.S. Treasuries, and we purchased a whole bunch of mortgage-backed securities. So it effectively—our balance sheet now is roughly $4.5 trillion. So we had, basically, a fivefold increase from back here before the start of the recession, to its current level. Okay? And—yes?
Male: I'm sorry. Could you explain how that was funded?
Cletus Coughlin: Well, we're one of those unusual institutions that we can just buy them. And we basically provide credits—we provide deposits for commercial banks.
Male: So you're saying, commercial banks deposited funds with the Fed?
Cletus Coughlin: We bought the treasuries.
Cletus Coughlin: Yeah. And we basically created those deposits. And we're not a normal institution. In other words, if you had normal business—
Male: Similar to printing money?
Cletus Coughlin: Yeah. Yeah, you can call it that way.
Male: So you funded 100% of QE 1, 2, and 3 with printed money?
Cletus Coughlin: Yeah. Correct.
Male: I don't—I looked at the Fed's balance sheet, and I see a lot of deposits from banks that show up on the liability side of the balance sheet.
Male: Those are reserves.
Cletus Coughlin: Those are the reserves that they have, and that's one of the things that these institutions can trade with each other. But of course, given that current interest rates are zero.
Male: Okay, but you're saying the Fed still has those deposits on reserve, but on response to this, they actually printed money?
Cletus Coughlin: Correct. In order to buy the—
Male: Somewhere, it shows up in the Federal Reserves?
Cletus Coughlin: Yeah.
Male: And that's a liability on us?
Cletus Coughlin: Yeah, and that was part—well, we'll explain this a little bit later on. The goal, of course, is to stimulate the economy via that, through the ability of commercial banks to make loans. Hopefully good loans, profitable loans, and so on. And that was part of our strategy. Okay, a quick one.
Male: Is there a limit to the amount of funds you can use on (inaudible)?
Cletus Coughlin: Is there a limit on our—
Male: Funds you can create (inaudible).
Cletus Coughlin: No.
Cletus Coughlin: Yes, we can.
Male: No limit?
Cletus Coughlin: No. Now, you know, there—clearly, we have certain mandates that we'll talk about here in a minute that, in terms of—it's conceivable that all that money could then generate a whole ton of inflation. But we have targets for those types of things, so we wouldn't let that get out of control. We can manage this balance sheet. Okay.
All right, so the unconventional policies here that we've undertaken are to lower the federal funds rate to basically zero, and to increase the size of the U.S. balance sheet quite dramatically. Okay? Now, over these years, subsequent to these actions, the U.S. economy has begun to recover, or has recovered to a significant extent. Maybe not as robustly, and as quickly as many of us would have hoped. But let me ask you a question, to get back to the last question about the U.S. economy. What is the Fed's mandate? In other words, what are the requirements, the goals, of Fed policy? Is it maximum employment? Is it price stability? Is it both one and two, or is it neither one nor two. So once again, if you go back to your clickers just so we can set the stage for what we're going to talk about in a minute. Okay, I think we're good here. All right.
The correct answer is three. We have a mandate for maximum employment, and we have a mandate for what we call price stability. Okay? And so that both of those that—what we have is what's called a dual mandate to satisfy both the employment and price stability requirements. So that as we attempt to assess what's happened over time, we want to look at those two things, to see where we're at in terms of the recovery. Okay? Now, this is the U.S. unemployment rate, okay? Once again, before the recession began, we were roughly slightly less than 5%, or right around 5% in terms of the unemployment rate. The unemployment rate shot up during the recession, and actually continued to increase just a little bit, beyond the end of the official recession so that it reached a level of 10%. Over time, as the economy has recovered, job growth has been very healthy, and we're now down in the range of 5.4%. Okay? So that on the basis of this mandate, you know, some would argue we're already to full employment. Others would argue we still have a little ways to go. But it's clear that we're very close to satisfying what would be a reasonable expectation as to what the unemployment rate should be. Okay?
Now, with respect to inflation, these are the two types. This is personal consumption expenditures index of inflation. There are three things here. One, our target is roughly to be in the neighborhood of 2%, in terms of inflation. And we have two measures of inflation here. The blue is what's called headline inflation, so this includes virtually everything in this. And you can see that in recent months, it's taken a sharp drop down. This is on a year over year basis. And so now we're down in the area of 0.3%. Okay? Now a large bit of that decline is a reflection of the decline in oil prices. So that if you were to strip out food and energy prices—now clearly we all buy food and energy, so I'm not suggesting that that's necessarily the thing to do—but in terms of looking at the chain index once we strip that out, we're in the neighborhood of 1.4%, 1.5% on a year-over-year basis on that. Okay?
So the real question is what's likely to happen to this over time? The Fed's suggests that over, what we call the medium term, that we're going to be back in the neighborhood of 2%. And certainly, as energy prices don't diminish any further, and clearly when energy prices increase we're going to see this headline number push back up in the neighborhood of 2%. Okay? So that's the expectation. So that we've now reached a point where there is much interest and discussion on what we call monetary policy normalization. Okay? And tonight, we will learn, hopefully, a great deal about what normalization is and hopefully what it would mean to return to a conventional monetary policy that existed prior to 2007.
Our speaker tonight, is Stephen D. Williamson, who is a V.P. in our research division. Steve joined the bank full time roughly a year ago. He's an import. He's been imported from Canada. He has his—
Stephen Williamson: Many, many years ago.
Cletus Coughlin: Yeah, that's right. Yeah. He's an old import. He earned his bachelor's and master's degrees from Queens University in Kingston, Ontario. In 1984, he was awarded his Ph.D. in economics from the University of Wisconsin-Madison. He has had a distinguished academic career. Immediately before joining the bank, he was the first Robert S. Brookings Distinguished Professor in Arts and Sciences at Washington University. I don't want to delay his presentation any more by listing his numerous publications, but the key point is that Steve is an internationally recognized expert in macroeconomics and monetary policy. So I'm pleased to present Stephen Williamson.