What Lies Ahead for the Federal Reserve

A recent speech by Janet Yellen gives us a very clear idea of what lies ahead for the U.S. economy and the Federal Reserve during the next (and already overdue when looking at averages) recession.  The speech, given on October 20, 2017, was entitled “A Challenging Decade and a Question for the Future” looks at the Fed’s progress in defeating the Great Recession over the past decade and how the Fed will fight future economic contractions.

Let’s look at some key quotes from her speech starting with her rationale for using unconventional monetary policies during and after the Great Recession and the effectiveness of these policies::

A substantial body of evidence suggests that the U.S. economy is much stronger today than it would have been without the unconventional monetary policy tools deployed by the Federal Reserve in response to the Great Recession. Two key tools were large-scale asset purchases and forward guidance about our intentions for the future path of short-term interest rates. The rationale for those tools was straightforward: Given our inability to meaningfully lower short-term interest rates after they reached near-zero in late 2008, the FOMC used increasingly explicit forward rate guidance and asset purchases to apply downward pressure on longer-term interest rates, which were still well above zero.

The FOMC’s goal in lowering longer-term interest rates was to help the U.S. economy recover from the recession and stem the disinflationary forces that emerged from it. Some have suggested that the slow pace of the economic recovery proves that our unconventional policy tools were ineffective. However, one should recognize that the recovery could have been much slower in the absence of our unconventional tools. Indeed, the evidence strongly suggests that forward rate guidance and securities purchases–by substantially lowering borrowing costs for millions of American families and businesses and making overall financial conditions more accommodative–did help spur consumption and business spending, lower the unemployment rate, and stave off disinflationary pressures.(my bold)

Here is a graphic showing what has happened to the Fed’s balance sheet since 2006:

As we can see from this graphic, despite the Fed’s “heroic measures” since the Great Recession began in late 2007, economic growth in the latest cycle has been rather poor compared to other cycles:

So, what lies ahead for the Federal Reserve?  Given that we are currently experiencing the third longest expansion since the end of the Second World War and that, at 103 months long, the current expansion is well above the average economic expansion length of 67 months as shown on this graphic:

…the Federal Reserve has to be considering what it will do when the economy starts to slow.  Here’s what Ms. Yellen had to say about the future:

My colleagues on the FOMC and I believe that, whenever possible, influencing short-term interest rates by targeting the federal funds rate should be our primary tool. As I have already noted, we have a long track record using this tool to pursue our statutory goals. In contrast, we have much more limited experience with using our securities holdings for that purpose.

Where does this assessment leave our unconventional policy tools? I believe their deployment should be considered again if our conventional tool reaches its limit–that is, when the federal funds rate has reached its effective lower bound and the U.S. economy still needs further monetary policy accommodation.

Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades.   Indeed, most FOMC participants now assess the longer-run value of the neutral federal funds rate as only 2-3/4 percent or so, compared with around 4-1/4 percent just a few years ago.   With a low neutral federal funds rate, there will typically be less scope for the FOMC to reduce short-term interest rates in response to an economic downturn, raising the possibility that we may need to resort again to enhanced forward rate guidance and asset purchases to provide needed accommodation

The bottom line is that we must recognize that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound.(my bold)

It is interesting to see that Ms. Yellen admits that the Federal Reserve has “much more limited experience with using its securities holdings” to influence interest rates.  Her final statement is also quite telling.  Even though the Fed is inexperienced with quantitative easing, she clearly believes that the Federal Reserve will be forced to use unconventional monetary policies once again, even in the case of a moderate recession.  Odds are quite good that the Fed will still have a massively bloated balance sheet when it is forced to go back into the market and load up with additional Treasuries and other fixed income products and, given Japan’s failure to stimulate its own economy with its even greater use of unconventional monetary policies, there is no guarantee that the Fed will meet with success the next time it needs to prod a contracting economy back to life.

Despite the fact that the Federal Reserve has no real idea about the impact of the unwinding of its $4.47 trillion inventory of Treasuries and mortgage-backed securities, it is already admitting that it will likely have to continue its experiment with quantitative easing during the next recession, even if it is a mild contraction.  As well, even though a decade and a half of QE hasn’t cured the ills that plague the Japanese economy, it’s full steam ahead for the Fed.

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