speeches · July 7, 2009
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 12 01 09
Nontraditional Monetary Policy and the Economic Outlook
Chamber of Commerce of St Joseph County
South Bend, IN
Introduction
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 nancial 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 bu ered overall job loss to some extent, this bu er 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 di er signi cantly from the standard
policies of the past The programs we have put in place are designed speci cally for these exceptional circumstances As such,
they will have to be unwound as our nancial 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
Nontraditional policies
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 nancial markets Under normal circumstances, participants seeking pro t opportunities tend to align risk-
adjusted returns across all markets This allows a change in the federal funds rate to ow 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
a ect 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 rst 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 nancial markets One can think of it as a sort of discount window for
nancial 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 di erent 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 rst
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
Insurance
To understand the rst 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 nancial
system, stable growth, and price stability We saw failures in parts of the nancial system, but did not know how serious they
were and how they would a ect the rest of the economy We also saw economic activity begin to deteriorate signi cantly, but
were uncertain how deep the downturn would be Finally, price levels declined for the rst time in decades, but we did not
know if we would slide into an extended period of de ation
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 de nition, we had little experience with these new policies
and were unsure how e ective 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 di erent remedies in quick succession, in the hope
that we may learn which ones work best without losing valuable time
Innovation
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 e ectively 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 nance their purchases of certain highly rated asset-backed securities, with the
securities themselves as collateral for the loans
The rst 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 ows 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
Rightsizing
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 a ect 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 signi cant deterioration relative to our outlook for me to view our current policies as
inadequate
Economic Outlook
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
rst 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 signi cant 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, nancial 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 at 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 atten 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 led
jobless claims seem to have peaked in late March However, rms 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 attens 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 xed investment remains weak, but the decline is getting shallower Steep inventory liquidations
made signi cant 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 scal stimulus will continue to have positive
in uences on the economy
Forecasting in ation is never easy, but these are particularly di cult 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 in ation forecast
for 2010 reported by Blue Chip Economic Indicators is more than twice what it was a year ago for in ation in 2009 Two
con icting 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 in ation Indeed,
some statistical models have pointed to possible de ation risks in the quarters ahead But in ation 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 in ation 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 in ation; and experience shows that a rise in in ation
expectations, once solidi ed, becomes embedded in many economic decisions and makes in ation harder to control
Currently, core in ation is near 2 percent, a level I generally nd acceptable In the near term, I think the downward forces on
in ation will be greater than the upward forces, and we could see some declines in core in ation But over the medium term I
see the risks to the in ation 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 nancial markets improve further
Nonetheless, a signi cant 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 in ation But I want to emphasize the middle link in this chain: In ationary 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
Conclusion
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 nancial 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
Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily re ect the views of the
Federal Reserve Bank of Chicago or the Federal Reserve System
Cite this document
APA
Charles L. Evans (2009, July 7). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090708_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20090708_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2009},
month = {Jul},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20090708_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}