Monetary Policy Normalization: Monetary Policy around the Great Recession

Stephen Williamson, a vice president and economist with the St. Louis Fed, examined the assets and liabilities on the Fed's balance sheet in the wake of the Great Recession. He also discussed why the Fed took unconventional monetary policy actions following the recession and looked at the performance of the economy in terms of the Fed’s dual mandate of price stability and maximum employment.

Presentation (PDF)

• 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

Transcript:

Stephen Williamson: But the Fed did stuff. The Fed did stuff during the Recession. So we'll look at first the liabilities side of the balance sheet, then the asset side. So the liability side looks like this. So not too much going on with the currency. Currency just kind of grows steadily here. There's kind of more of it, you know? There's more demand for currency that comes—the Recession is kind of the shaded area in here. Before the Recession, currency holdings in the U.S. are about 6 percent of GDP, and after, they're about 7 percent. So currency holdings kind of go up. There's greater demand for currency. Some of that's in the rest of the world. But not too much action there. But you can see the huge amount of action in reserves. Reserves just a little—it looks tiny here. But this tiny bit of reserves, that's the stuff that's financing the—you know, the annual GDP per day, you know, in financial transactions. That stuff's turning over really fast, every day.

Small amount of reserves, not a huge amount of reserves after the Recession. It goes up in several steps, due to these large scale asset purchases, which you'll see—we know that anything you see happening on the liabilities side of the balance sheet is going to show up in the asset side too, assets equal liabilities, basically. So here's the asset side. So I wanted to decompose this by the different components, so you could kind of see what's going on. So over here, you can see pre-financial crisis, what it looks like. So here's the assets on the Fed's balance sheet. So they're Treasury Securities, but they're different kind of maturities of Treasury Securities. We've got short maturity and long maturity, basically. The short maturity are the Treasury bills. Long maturity are the Treasury bonds. They're like notes and bonds. I just call it key bonds, here. It's anything long maturity. Then there's some other stuff in here. These are repos—repurchase agreements. That's another asset for the Fed. What it is, is it is lending. That's really short term. That's overnight, mostly. Overnight secured lending in the market for repurchase agreements. Conventional monetary policy was about that. Was about intervening in overnight markets, to control the Fed funds rate. The Fed funds rate target, you try to hit that by manipulating the amount of repos the Fed does every night. That's how they intervene.

So that's how—so you can see how the intervention was in terms of quantities before the recession. That's these little wiggles in here. That's what's controlling interest rates. Then after the Recession, it looks very different, right? It looks radically different. This is like a situation where—so you've increased the total size of the balance sheet by more than four times. And now we've sort of got rid of all the short-term stuff. Treasury bills go to zero on here. We got rid of all that. And what we got are long-term stuff. Not only the Treasury bonds, that's the blue line here. But something here. MBS, those are mortgage-backed securities. So those are assets back. Those are different now. That's unconventional, because the underlying assets are private assets. It's not government debt. It's private assets that we're buying here. It's safe stuff. It's not like there's anything risky about it. But it's different. So it's huge purchases of that stuff.

So this is crisis intervention. So you see the crisis intervention in here again. This is loans, here. This purple line. So you see that going way up. That's like a big number, in terms of what's going on back here. So that's crisis intervention. Bank of England, right? So that's by the book, essentially.

So we want to understand what you—here's the balance sheet out here, looks very different from how it looked back here. So somehow, you want to think about it, how do you return this kind of balance sheet to this? How do you get from there, back to that? Another aspect, of course, of this is just our interest rate target. This is actual Fed funds rate. That's not the target. That's the market rate. And Cletus showed you this picture. This is unprecedented, a period of close to zero, nominal short-term interest rates in the United States. It doesn't exist post-World War II, which is sort of modern era of central banking is sort of post 1951, would be more accurate. So this is very unusual. So the size of the balance sheet, that's unusual. Having interest rates this low for that long, very unusual, too.

Okay, so why did we do that? So one reason would be this. So here's a comparison between, like, a—this is the '81-'82 recession, the blue line. This is the more recent one. What we're looking at here, is the number of quarters since the start of the recession. So this zero here would be for the most recent recession would be the last quarter of 2007, and then out here is where we are now. So the '81-'82 recession was severe in post-World War II history. This one was severe, but the recovery is very different, right? So the '81-'82 recession, this is real GDP, it bounces back much more quickly than this does. So if you see this happening, you get worried about it. And so the worry was, well, the interest rates have gone to zero. What do you do now? This looks like a real problem. Maybe the Fed can do something about it. So they pulled out the stops, and decided to engage in these long—these large-scale asset purchases, to try to deal with that problem. Here's another way of looking at it, is this is like real GDP, you know, going back to 1980. I've done it on a long scale, so you can see the slope is kind of roughly the growth rate here. So you can see what's happening out here, where we are now. It seems like what happened after the recession, which is again, the shaded region here, is that there's this dip in real GDP. Usually what would happen is that the economy comes back. It kind of comes back to trend. Over 100 years, or so, in the U.S., trend means 3 percent real GDP growth per year. And this is more like 2 percent out here. So normally what would happen, is you kind of make up for the recession. You grow at more than 3 percent for a while, and you get back to trend. And that's not happened.

So that's unusual. So the situation is unusual, and the idea is the unusual situation calls for unusual policy. Okay, so the dual mandate is the instructions we get. The instructions we get from Congress about what we're supposed to be doing. The dual mandate, it says we're supposed to make prices stable and provide maximum employment. So there are different ways you can interpret that, but one way to think of it is—well, the way we've interpreted the price stability is 2 percent inflation target. Two percent inflation, in terms of this measure here. This blue here is the PCE deflator inflation rate. From rate of increase from a year previously. The red here is what you take out energy and food. Which is just useful as a benchmark. The thing we care about is what affects consumers, which is the whole business, you know? It's the PCE deflators, we think are our best measure of prices in the economy. For various reasons, better than the consumer price index. That's why we use it.

Okay, so in terms of our price stability goal, which is 2 percent inflation per year, which you know, should make things predictable in terms of making economic decisions, we're on the low side here. So in spite of all this, you might think that having all these reserves out there is going to be inflationary. Well, it's not. The reserves effectively—so they earn interest, and they're really like—they sit, and they're like Treasury bills. People aren't spending the reserves. They're sitting in banks' portfolios. If you think about it, it's pretty clear why you need not be inflationary. And it's not. So in fact, we're below our inflation target. Inflation's not high enough, in terms of the goal we set for ourselves. Unemployment rates coming down. Cletus showed you this picture. In fact, it's come down actually—from this recession; it's come down faster than these previous ones. You can see the rate of decrease from the previous recessions was slower than it was here. This was actually a surprise. A surprise that the unemployment rate came down so quickly. So you got some of this—there's some aspects of the performance that are bad. When you look at GDP, and you got this kind of drop in the growth rate. But unemployment looks not so bad.