Regional President Speech

U.S. Monetary Policy: Assessing Strategy and Effectiveness Norges Bank September 27, 2013 Charles L. Evans President and CEO Federal Reserve Bank of Chicago The views I express here are my own and do not necessarily reflect the views of the Federal Reserve Bank of Chicago, my colleagues on the Federal Open Market Committee (FOMC) or within the Federal Reserve System. 1 Overview 1. Strategy for U.S. Monetary Policy 2. Have non-traditional policies at the ZLB been effective? 3. Monetary Policy, Financial Stability and Macro- Prudential policies Section 1. Strategy for U.S. Monetary Policy Multiple Choice Quiz  The objective of Monetary Policy in the U.S. is to: – a. Mechanically adhere to a simple policy rule – b. Implement the popular monetary policy du jour – c. Provide financial and monetary conditions to facilitate maximum employment and price stability – d. None of the above Current Scorecard for the U.S.  Unacceptably high unemployment  Inflation is well below long-run inflation objective  Simple policy rules break down at ZLB Understanding U.S. Monetary Policy  Possible Strategies – Business as usual – Not business as usual at the ZLB Can require some unpopular monetary policies   Central Bank independence is crucial. If independence means anything… – Pursue best policies to meet statutory objectives – No matter how unpopular [cf Volcker Fed] – And be held accountable to democratically elected officials What if There Was a Single Mandate in U.S.? Total PCE Price Index Expected Future Three-Year Ahead (level) Inflation (percent) Dec. 2007 120 2.5 2% Price-Line from December 2007 110 Expected Inflation for 2020-2023 (as of 2020) Path Implied by Current 2.0 FOMC Inflation Total PCE Forecasts 100 Expected Inflation for 2013-2016 (as of 2013) 90 1.5 2007 2009 2011 2013 2015 2013 2014 2015 2016 2017 2018 2019 2020 Source: Inflation forecasts are from the September 18, Source: FRB-Chicago Staff Models 2013 FOMC Summary of Economic Projections Long-Run Strategy for Monetary Policy (January 2012 and January 2013)  π* = 2% PCE inflation  U * ~ 5¼% - 6% time-varying t SEP long-run central tendency  Balanced approach to reducing deviations of inflation and employment from long-run objectives Balanced Approach to the Dual Mandate is Consistent with Mainstream Macroeconomics Loss Function L = (π - π*)2 + 0.25 (y – y*)2 (percent) L = (π - 2)2 + (u – un)2 π=5.5% FOMC Forecast (September 18, 2013) u=9% 2015 September 2011 2014 Current Value value The Problem is the Zero Lower Bound Federal Funds Rate (percent) 6 Taylor Rules: Optimal Control: R = 2.0 + π + 0.5(π – 2) + α gap t t t t Min (π – 2)2 + (u - un )2 + ΔR2 Taylor 1999: α = 1.0 t t t 5 Taylor 1993: α = 0.5 4 3 Optimal Control Taylor 1999 Taylor 1993 2 1 0 2011 2012 2013 2014 2015 2016 2017 2018 Source: Janet L. Yellen, “Perspectives on Monetary Policy,” Boston, June 6 2012 Asset Purchases: The Fed’s Balance Sheet Federal Reserve Assets (Bils. $) 4000 11-Sep-2013W 3500 3000 2500 2000 1500 1000 500 0 2007 2008 2009 2010 2011 2012 2013 All Other Assets ($304.8 bil.) Treas. Sec ($2,038.3 bil.) Agency Debt ($64.4 bil.) Agency MBS ($1,291.5 bil.) Lending and Liquidity Facilities ($2.2 bil.) Forward Guidance on the Federal Funds Rate  December 2012: “Economic conditions likely to warrant exceptionally low level of the funds rate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half of a percentage point above the Committee’s 2 percent long-run goal, and longer-term inflation expectations continue to be well-anchored.” FG and FOMC “Appropriate” Policy Rates 6 5 Taylor '93 Inertial Taylor '99 6.5% threshold, then inertial Taylor '99 4 3 2 Mkt. Exp: 2014 Q4: 0.30 2015 Q4: 0.91 2016 Q4: 1.76 1 0 2013 2014 2015 2016 Long-Run Source: Interest rate forecasts are from the September 18, 2013 FOMC Summary of Economic Projections; market expectations from OIS futures, September 19, 2013 Change in Fed Funds Rate Expectations Fed Funds Rate (percent) 6 Central Tendency of 5 FOMC Long-Run Projections 4 3 History September 19 Market Expectations September 10 Market Expectations 2 June 18 Market Expectations April 23 Market Expectations 1 Aug-2013 0 2007 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 Section 2. Have non-traditional policies at the ZLB been effective? Policy Evaluation  Common op-ed page policy evaluation: – “After $3+ trillion of asset purchases and all this forward guidance, there has been no effect on the economic recovery. Therefore nontraditional monetary policy has been impotent.”  Standard economic policy evaluation: – What does economic theory say? – What do the data say? – Have all important factors been accounted for in the data analysis? (controls) – What assumptions are required for this evaluation to be meaningful? Reviewing Data: Facts About Growth (percent change at an annual rate and contribution to annualized percent change) 2007:Q4 2009:Q2 2010:Q4 to to to 2009:Q2 2010:Q4 2013:Q2 GDP -2.9 2.7 1.9 Contribution to growth: PDFP1 -3.8 2.1 2.3 Gov 0.7 -0.1 -0.5 NX 1.2 -0.5 0.1 CBI -1.0 1.2 0.0 1. Private domestic final purchases Headwinds Contributing to Weak recovery  Fiscal  International  Hangover from housing collapse Federal + State and Local Purchases Weak Government Contributions to Real GDP Growth (percent) 0.75 Federal State and Local 0.5 0.25 -2E-15 -0.25 -0.5 -0.75 2008 '09 '10 '11 '12 '13 Historically Unusual Government Contributions to Real GDP Growth (percent) 3 2 1 0 -1 1965 '70 '75 '80 '85 '90 '95 2000 '05 '10 World Growth Real World GDP Growth (4-quarter percent change) 6 2 year ahead IMF forecasts 1 year ahead IMF forecasts Actual (2013 and 2014 are July 2013 forecasts) 5 4 3 2 1 0 -1 2009 2010 2011 2012 2013 2014 Source: International Monetary Fund April World Economic Outlooks except as noted European Sovereign Debt Spreads (spread to German long-term rates) 30 France Italy Greece 25 20 15 10 5 0 2006 '07 '08 '09 '10 '11 '12 '13 Household Deleveraging Household Liabilities Owners’ Equity (% of DPI) (% of household real estate) 150 80 Home Mortgages Q1-2013 Consumer Credit Other Debt 120 70 90 60 Q1-2013 60 50 30 40 0 30 1975 '80 '85 '90 '95 '00 '05 '10 1975 '80 '85 '90 '95 2000 '05 '10 Volatility in Treasury Rates also Informs Economic Factors for Growth Ten-Year Treasury Bond Yield (percent) Jackson Debt limit QE 1 Swap lines Hole QE 2 showdown MEP QE 3 JEC 4.50 3.75 3.00 2.25 1.50 0.75 2008 '09 '10 '11 '12 '13 LSAP Effects  Wide range of estimates regarding the effect of LSAP on Treasury rates through – Portfolio balance effect on term premia – Signaling effect on expected future short-term rates  Reasonable estimate is $500 billion of LSAP worth about 25 bps on 10-year Treasury rates Empirical Facts about Term Premia Source: Ben Bernanke, “Long-Term Interest Rates,” San Francisco, March 1, 2013 Lessons from the 10-Year Treasury Rate  Change in rates and term premia are larger than what can be explained by reasonable estimates of portfolio balance and forward guidance  Many factors influenced 10-year Treasury rates – Is it plausible that these and other factors had “no effect” on growth and inflation experience in U.S.? (importance of controls)  We need counterfactual accounting – First class in Econ 101: supply and demand equilibrium – Second class in Econ 101: comparative statics Accounting for Growth: It Takes a Model  Medium scale New Keynesian DSGE model  Demand shocks: Discount factor, interest rate spread, net worth, “NIPA residual” (GOV+NX+CBI)  Supply shocks: Neutral technology, investment specific technology, wage and price markups  Policy shocks: Current target and forward guidance on the funds rate, inflation expectations  Estimated using standard (Bayesian) methods Forward Guidance: Theory and Evidence  Bedrock principle for Monetary Policy: lower rates support higher economic activity  At the ZLB, does forward guidance lower rates and increase activity? Effects of Forward Guidance Estimates from Chicago FED DSGE model DSGE Model Forecasts of GDP 2008Q1-2009Q2: Great Recession Conditional Forecast Error Decomposition Demand Policy Total GDP -8.1 -3.2 -13.4 Consumption -8.2 -1.5 -12.4 Core PCE Inflation -5.4 1.2 -3.0 Federal funds rate -7.9 1.2 -7.5 Percentage point errors in forecasts made in 2007:Q4 for the 2009:Q2: level of GDP and consumption; quarterly percent change (annual rate) in core PCE; quarterly-average federal funds rate. • Severe downturn for all macro variables compared against expected solid growth for the period. • Weak Demand drove downturn, particularly the discount factor/beta shock • Contractionary target and FG policy shocks also a drag on GDP owing to ZLB. 2008Q1-2009Q2: Great Recession 2009Q2-2010Q4: “Green Shoots”  As of spring of 2009, the model forecast saw continuing decline, as follow-through from large previous shocks.  Overall, GDP outperformed model forecast by 1.4 percentage points.  Favorable forward guidance shocks accounted for 1.2 percentage points. 2009Q2-2010Q4: “Green Shoots” 2011Q1-2013Q1: Massive Headwinds Conditional Forecast Error Decomposition Demand Policy Total GDP -2.1 1.0 -5.1 Consumption 0.9 0.4 -0.6 Core PCE Inflation -0.8 0.4 0.6 Federal funds rate -1.6 -0.2 -1.1 Percentage point errors in forecasts made in 2010:Q4 for the 2013:Q1: level of GDP and consumption; quarterly percent change (annual rate) in core PCE; quarterly-average federal funds rate. • Model forecast more robust recovery; but output actually fell relative to trend. • Adverse demand and supply shocks contribute substantially to weak GDP. • Principle demand shock was model NIPA residual (GOV+NX+CBI). • Policy shocks offset 1 percentage point of adverse shocks; but past policy shocks also provided uplift for conditional forecast. 2011Q1-2013Q1: Massive Headwinds Section 3. Monetary Policy, Financial Stability and Macro-Prudential policies MP and Financial Stability: Mandates and Tools  Tensions from low interest rates – Appropriate MP accommodation at ZLB – Incentivize additional risk-taking: cross-current  Degrading MP tools to mitigate Financial Instability risks would lead to inflation below target and additional resource slack.  In order to avoid excess risk-taking, use combination of Supervisory oversight, macro-prudential tools (separate from MP tools), and Market Discipline

Charles L. Evans (2013, September 26). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20130927_charles_l_evans

@misc{wtfs_regional_speeche_20130927_charles_l_evans,
  author = {Charles L. Evans},
  title = {Regional President Speech},
  year = {2013},
  month = {Sep},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20130927_charles_l_evans},
  note = {Retrieved via When the Fed Speaks corpus}
}