macroblog

Reviewing the recession: Was monetary policy to blame?

Reviewing the Recession: Was Monetary Policy to Blame?
In a recent speech given at the University of South Alabama, Federal Reserve Bank of Atlanta President Dennis Lockhart added his voice to what is now the general consensus: "I agree with all who are declaring that a technical recovery is under way."

There is still much work to be done, of course, not least the continuing examination of just what led to the recession and how a repeat performance can be avoided. One theme of this examination appeared in last week's Financial Times:

"It is certainly true that the most recent bubble, its bursting and the Fed's actions in the aftermath have inspired existing critics and recruited new ones. The first charge is that interest rates under Alan Greenspan, [current Fed Chairman Ben] Bernanke's predecessor, were kept too low for too long, contributing to a bubble of easy credit."

Here is an exercise that that I find intriguing. Suppose we try to estimate, as closely as we can, the actual interest rate decisions of the Federal Open Market Committee (FOMC) over the period spanning the beginning of Greenspan's tenure to the present. It turns out that by using an approach based not only on measures of inflation and actual output relative to potential but also on the lagged fed funds rate, you can actually get pretty darn close to statistically describing what the FOMC did:

I'm going to resist the temptation to call this approach a "Taylor rule." The estimating "rule" used here does in fact include realizations of inflation and a measure of the output gap (that is, a measure of how different gross domestic product is from its potential). These are the essential ingredients of the Taylor rule, but not the source of the close fit evident in the chart above. Over the period covered by the chart, you could have done a pretty good job mimicking the actual federal funds rate outcomes in any given month using knowledge of the previous month's rate. (If you are interested in the details of the estimating rule, you can find them here.)

The interpretation of the tendency for today's federal funds rate to generally follow yesterday's rate—sometimes referred to as interest rate smoothing—is controversial. Glenn Rudebusch (from the Federal Reserve Bank of San Francisco) explains:

"Many interpret estimated monetary policy rules as suggesting that central banks conduct very sluggish partial adjustment of short-term policy interest rates. In contrast, others argue that this appearance of policy inertia is an illusion and simply reflects the spurious omission of important persistent influences on the actual setting of policy."

Rudebusch is decidedly in the second camp, but for our purposes here the exact interpretation may not be that important. Though I am glossing over some not insignificant caveats—such as the difference between final data and the information the FOMC had to react to in real time—the chart above suggests that whatever the underlying structure of policy decisions, after the fact the FOMC appears to have behaved in an extraordinarily consistent way over the period extending from the late 1980s. This observation, in turn, suggests to me that there was nothing all that unusual about monetary policy in 2003 once you account for the state of the economy.

Which leads me to my main point on the chart above: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with "proven" success as it set interest rates through the dawning of the new millennium.

There is, of course, the possibility that the pattern of the funds rate depicted in the chart above was incomplete all along in the sense that whatever variables are explicit and implicit in the estimated rule, they did not include information to which the FOMC should have responded. In calmer times, the story would go, not including potentially pertinent information was not much of a problem. Eventually the missing-data chickens could come home to roost. The prime omitted variable suspect would, of course, be some sort of asset prices.

Scratch any gathering of macroeconomists these days and out will bleed a steady stream directed at incorporating credit and financial market activity into thinking about the aggregate economy. The necessity of proceeding with that work was emphasized by no less an authority than Don Kohn, vice chairman of the Federal Reserve Board of Governors, speaking at just such a gathering of macroeconomists last week:

"It is fair to say, however, that the core macroeconomic modeling framework used at the Federal Reserve and other central banks around the world has included, at best, only a limited role for the balance sheets of households and firms, credit provision, and financial intermediation. The features suggested by the literature on the role of credit in the transmission of policy have not yet become prominent ingredients in models used at central banks or in much academic research."

I will admit that economists were not exactly ahead of the curve with this agenda, but prior to 2007 it was not at all clear that detailed descriptions of how funds moved from lenders to borrowers or how short-term interest rates are transmitted to longer-term interest rates and capital accumulation decisions were crucial to getting monetary policy right. Models without such detail tended to deliver policy decisions not far from the sort depicted above, and, as I noted, they seemed to be working quite well in terms of macroeconomic outcomes.

Thus far, one of the lessons from models in which financial intermediation is taken seriously is that interest rate spreads or stock prices or other asset prices do become part of the policy rate recipe. Your response might well be something along the lines of "duh." You are entitled to that opinion, and I won't push back too hard. But it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate caused by the failure to make whatever adjustments might have been indicated by the inclusion of pertinent financial variables in implicit rate-setting rules of thumb. Furthermore, early versions of research I have seen that combines capital regulation policy and interest rate policy suggest that the macroeconomic consequences of getting the former wrong may be much greater than the consequences of getting the latter wrong. To me, that conclusion has the ring of truth.

By David Altig, senior vice president and research director at the Atlanta Fed

How fast can the economy grow?

The recession may be ending (and may, in fact, have ended, according to the majority of economists recently surveyed by the Wall Street Journal) but, as Friday's consumer confidence report suggests, the uncertainty about the course of future growth is far from resolved. The most recent consensus forecast from the panel assembled for the monthly Blue Chip Economic Indicators does suggest a nice bounce back into positive growth territory, bringing to an end a four-quarter run of gross domestic product (GDP) contraction.

What remains interesting, however, is the range of disagreement about just how fast the recovery will be. The upper and lower black lines in the chart above delineate the 10 most optimistic forecasts (the upper lines) and the least optimistic forecasts (the lower lines) among the Blue Chip panel's 51 economists. Most interesting is the fact that some collection of theses economists are, in any given quarter, guessing that growth will not break a 2 percent annual pace before we exit 2010.

That uncertainty is compounded by an even more consequential uncertainty, lucidly emphasized recently by Menzie Chinn (here, here, and here): How fast can we grow before straining the economy's capacity? In other words, is slow growth the best we can expect given the economy's current potential?

The output gap—the difference between the current level of GDP and estimated potential—has long been standard fare in policy analysis. Over at iMFdirect, the International Monetary Fund's blog, Ajai Chopra explains why we care:

"What would be merely a curiosity during better times—after all, potential output is a largely abstract concept measuring the level of output an economy can produce without undue strain on resources—has become a particular worry in the context of the global economic crisis…

"Right now, budget planners across Europe are scrambling to estimate the strength of the blow the crisis has dealt to public finances, and not knowing the growth potential of their economies greatly complicates their task. If they overestimate potential growth, they would underestimate the need for fiscal adjustment once the crisis has dissipated, raising thorny issues of fiscal sustainability in the longer run.

"Central bankers, too, are looking for guidance on the path of potential output. Their decision on when to start winding down current crisis policies depends on the difference between potential and actual output, the so-called output gap. If the output gap is closing faster because of a drop in potential, policymakers might decide to increase interest rates a little earlier and a little higher to prevent  inflation from rising."

Economists also do not lack methods for estimating the output gap and, just in case the field is not crowded enough, Atlanta Fed economist Jim Nason has done some investigating of his own. Jim looked at a variety of statistical estimates of the output gap and arrived at what is now a pretty familiar conclusion. To wit, there is substantial variation in output gap estimates across the different methods, and I do mean substantial: The gap estimates for the second quarter of 2009 range from –0.5 to nearly –11 percent depending on which method is used. In other words, some methods imply the gap is very large, others say the gap is rather small.

I am tempted to invoke the ancient economists' chant, "noh-bah-de-noz," but real-life policymakers don't have that luxury. So we delve in the details and try to sort out what seems like the best approach. (If you have a technical bent, you can do the same with Jim's estimates by following this link.) As we sort it out, though, Ajai Chopra gives some sound advice:

"As for central bankers, they should also act on the information they have, although researchers such as Athanasios Orphanides (now Governor of the Central Bank of Cyprus and member of the ECB's Governing Council) have sensibly suggested that central banks should tread carefully by reducing the importance of the output gap in their decision making.

"More generally, policymakers—be they in the central bank or in the ministry of finance—would do well by communicating their assumptions about potential output growth to the public."

With that in mind, I will leave you with the recent communication on the subject offered by Federal Reserve Bank of Atlanta President Dennis Lockhart:

"Many observers see substantial slack in the economy that could persist for some years. Economists' more formal term for slack is "output gap." We at the Atlanta Fed see a meaningful output gap developing, but in our view it is smaller than would normally be associated with the weak pace of growth we expect over the next couple of years because all the obstacles to the natural pace of growth already mentioned have brought down the economy's potential for the medium term."

So, as President Lockhart indicates, mark us down, for now, on the low end of output gap scale.

Update: The San Francisco Fed's John Fernald and Kyle Matoba offer some related thoughts in the newest edition of the Bank's Economic Letter (hat tip to Econbrowser).

By David Altig, senior vice president and research director at the Federal Reserve Bank of Atlanta

Debt and money

If you are hunkered down on inflation watch, yesterday's news offered some soothing words. From Reuters:

"Chinese officials have expressed concern that heavy deficit spending and an ultra-loose monetary policy could spark inflation, eroding the value of China's U.S. bond holdings.

"But [U.S. Treasury Secretary Timothy] Geithner said: 'We have a strong, independent Fed and I am completely confident they have the ability to do their job under the law, which is to keep inflation stable and low over time, and that they will be able to—and certainly intend to—unwind these exceptional measures as soon as they have served their purpose.' "

And from Bloomberg:

"He said that there was 'no risk' of the U.S. monetizing its debt, a response to a question about whether the government would seek to finance the national debt by expanding the money supply and thus trigger a rise in inflation."

Concerns about such monetization arose in the wake of the FOMC's decision at its March meeting to purchase up to $300 billion of longer-term Treasury securities and that decision's coincidence with the very large fiscal deficits contemplated in President Obama's budget proposals. Those concerns have accelerated as longer-term Treasury yields have moved higher since.

There will, I trust, be plenty of opportunity to expand on these concerns as things develop, but for now I will offer just a little perspective in the form of the chart below, which shows the recent and (near-term) prospective shares of federal debt held by the Federal Reserve. The red line represents the share of debt that will be held by the Fed at the end of fiscal year 2009 if the $300 billion Treasury purchase program is completed and the federal deficit emerges as currently predicted by the Congressional Budget Office.

The financial crisis has, of course, borne witness to the shift in the Fed's balance sheet from Treasuries (which have been much in demand by the private sector) to a variety of loans and mortgage-backed securities. The consequence has been a sharp fall in the fraction of government debt held by the central bank, a fact that will be little changed under the current trajectory of Fed purchases and projected deficit spending.

A large decline in Fed holdings of Treasury bills—securities that mature in one year or less—drives much of the pattern seen in the chart above. The drop-off in share is not as large for Treasury notes—securities in the two- to ten-year maturity range, and some assumptions have to be made to get a picture of how the Fed's share might evolve over the near term. Without knowing how this evolution will occur, I developed two general assumptions for argument sake. If net new issues of Treasury debt follow historical averages, meaning just over half of net new debt is in the form of notes, and if the central bank applies the remainder of the $300 billion of longer-term Treasury purchases (about $170 billion at the end May) to notes, then the Fed would hold roughly 13 percent of the outstanding stock by the end of the year. If the Treasury were to issue nothing but bills or bonds, a $170 billion purchase of notes by the Fed would bring its share up to the neighborhood of 17 percent. Though these numbers are not as unusually low in historical context as is the case for total outstanding debt, neither would they jump off the page as an extreme aberration in the other direction.

Some might argue that "monetization" these days involves a whole lot more than government debt, but Chairman Bernanke has been pretty clear about his intentions regarding the overall size of the Fed's balance sheet. And, as I see it, so far allegations that extraordinary steps are being taken specifically to accommodate fiscal deficits are properly characterized as risk rather than fact.

By David Altig, senior vice president and research director at the Atlanta Fed

A new accord?

As days go in the U.S. Treasury market, Wednesday was a rough one. Bloomberg News described the day's developments as follows:

"The difference in yields between Treasury two- and 10-year notes widened to a record on concern surging sales of U.S. debt will overwhelm the Federal Reserve's efforts to keep borrowing costs low. …

"The unprecedented government borrowing has created concern about a rise in consumer prices. Policy makers have expanded the Fed's balance sheet to $2.2 trillion while excess reserves at U.S. banks have increased to $896.3 billion.

" 'Inflation is in the headlight of many investors,' wrote Andrew Brenner, co-head of structured products and emerging markets in New York at MF Global Inc., in a note to clients today."

By cosmic coincidence, I was reading that story in Tokyo as I prepared to chair a session at the Bank of Japan's 2009 International Conference on Financial System and Monetary Policy Implementation in which Marvin Goodfriend (Carnegie-Mellon professor and former Richmond Fed policy adviser) presented his thinking on keeping the central bank's inflation objectives firmly in hand at a time of rapidly rising government debt and large increases in the Fed's balance sheet. Professor Goodfriend's case is laid out in a paper titled "Central Banking in the Credit Turmoil: An Assessment of Federal Reserve Practice" (which was also presented at a conference devoted to research on the interactions between monetary and fiscal policy—that is, government spending and tax—co-sponsored by Princeton University's Center for Economic Policy Studies and Indiana University's Center for Applied Economics and Policy Research). Goodfriend pulls no punches:

"The 1951 'Accord' between the United States Treasury and the Federal Reserve was one of the most dramatic events in U.S. financial history. The Accord ended an arrangement dating from World War II in which the Fed agreed to use its monetary policy powers to keep interest rates low to help finance the war effort. The Truman Treasury urged that the agreement be extended to keep interest rates low in order to hold down the cost of the huge Federal government debt accumulated during the war. Fed officials argued that keeping interest rates low would require inflationary money growth that would destabilize the economy and ultimately fail.

"The so-called Accord was only one paragraph, but it famously reasserted the principle of Fed independence so that monetary policy might serve exclusively to stabilize inflation and the macroeconomic activity. …

"The enormous expansion of Fed lending today—in scale, in reach beyond depository institutions, and in acceptable collateral—demands an accord for Fed credit policy to supplement the accord on monetary policy. A credit accord should set guidelines for Fed credit policy so that pressure to misuse Fed credit policy for fiscal purposes does not undermine the Fed's independence and impair the central bank's power to stabilize financial markets, inflation, and macroeconomic activity."

Goodfriend's "new accord" amounts to asserting a set of principles that would reinforce price stability as the central goal of monetary policy, set the Fed down the road of extricating itself from the extraordinary credit market interventions of the past year-and-a-half, and join the central bank and Treasury in common cause toward the goal of doing everything possible to make sure that the Fed and Treasury don't go there again.

The paper was provocative, but it also raised a couple of fundamental questions. In particular, what is the degree of autonomous fiscal risk-taking appropriate to allocate to a central bank? If such powers are granted, how often and under what conditions ought those powers be exercised? And how far should the powers reach? If, as Goodfriend states, "the central bank's power to stabilize financial markets, inflation, and macroeconomic activity" requires lender-of-last-resort interventions—and hence pure credit policy interventions—what does that imply about the appropriate scope of monetary and regulatory authorities going forward? If the "shadow banking system" is the de facto banking system of the modern era—as Yale University's Gary Gorton argued in a paper presented at the Atlanta Fed's annual Financial Markets Conference held earlier this month—is the central bank's lender-of-last-resort function meaningful if narrowly construed (that is, if it fails to reach the shadow banking system)?

These, really, are first-order questions. On to the debate.

By David Altig, senior vice president and research director of the Atlanta Fed

When is rapid growth in a central bank's balance sheet not cause for concern?

The unprecedented growth in the Federal Reserve's balance sheet during the past year has generated considerable debate about potential problems for the economy down the road (see for example, here, here, and here). But a big change in the size of a central bank's balance sheet in a relatively short space of time is not necessarily a precondition for problems down the road. A case in point is New Zealand circa 2006.

In July 2006, the Reserve Bank of New Zealand (RBNZ) changed the monetary policy operating system from a channel or corridor system (like that used in Australia and Canada) to a floor system (see Neild 2006 for a description of this transition). Under this floor system, the RBNZ stopped offering free collateralized daylight credit to banks for settlement purposes. In other words, they removed the distinction between daylight and overnight reserves. Also under this new system, reserves were remunerated at the official cash rate (OCR), the RBNZ's target interest rate. Banks have access to RBNZ credit if needed as well, but at a rate 50 basis points above the OCR.

By the end of 2006 the target supply of bank reserves had increased sufficiently to allow for the smooth operation of the New Zealand payment system. The new level fluctuated around NZD 8 billion and represented an increase of 400 times the level under the previous regime. Todd Keister, Antonie Martin, and James McAndrews from the New York Fed have an interesting article describing the economics of a floor system. In that paper the authors stress that a floor system severs the link between the quantity of reserves and the target interest rate. A central bank could increase the supply of reserves—either for settlement or liquidity purposes—without changing the stance of monetary policy (the target interest rate).

Well, that's the theory. What about in practice? Did New Zealand's economy collapse under the weight of an inflationary spiral created by an explosion in the central bank money? In short, the answer is no. Because these newly created reserves were staying within the banking system there was no upward pressure on the broader money supply. For instance, M1 (currency plus checkable deposits) was NZD $22.9 billion in July 2006, and a year later it stood at $22.2 billion—a change that would not scare even the most hardcore monetarist.

Could a floor system work in the United States? Possibly. For one thing, with total reserve balances at the Fed about 18 times as large as they were a year ago there has been a sharp decline in demand for daylight overdrafts. Average daylight overdrafts for funds were $52 billion in the first quarter of 2008, but a year later that level had fallen to around $8.9 billion. With so many reserves in the system, the need for intraday borrowing from the Fed has decreased sharply. Of course, there are some big differences between the financial systems of New Zealand and the United States, including the fact that not all institutions depositing funds with the Fed are eligible to earn interest on reserves. But I do think the floor system provides some interesting food for thought—kiwifruit, perhaps.

By John Robertson, a vice president in the Research Department at the Atlanta Fed

Snapping ropes and breaking bricks

James Hamilton of Econbrowser is concerned about the current state of monetary policy. On the blog, Jim writes:

"I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.

"The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward."

After I looked up "pullulating," I found much to agree with in Professor Hamilton's description—or at least I did up to that last sentence. I certainly share his discomfort with a presumption that "Fed officials are better able to make… decisions than private investors," but that doesn't quite capture my view—and I emphasize my view—of how nontraditional policy is supposed to work. My own description of what the "fundamental transformation" of central bank policy is all about appears, hot off of the virtual press, in the first quarter issue of EconSouth, the Atlanta Fed's regional economics publication:

"I have a simple way of thinking about how monetary policy works. Imagine a long rope. At one of end of the rope are short-term, relatively riskless interest rates. Farther along the rope are yields on longer-term but still relatively safe assets. Off at the other end of the rope are multiple tethers representing mortgage rates, corporate bond rates, and auto loan rates—the sorts of interest rates that drive decisions by businesses and consumers. In the textbook version of central banking, the monetary authority grabs the short end of this allegorical rope, where the federal funds rate resides, and gives it a snap. The motion ripples down and hopefully reaches longer-term U.S. Treasury rates, which then relay the action to other market interest rates, where the changes reverberate throughout the economy at large.

"That's the story in normal times, and over the past year and a half the Federal Open Market Committee (FOMC) has done a fair bit of rope-snapping. In August 2007 the FOMC set the federal funds rate target—the overnight rate on loans made between banks—at 5.25 percent. As of December 2008, the rate target was lowered to a very low range of 0–0.25 percent. As the committee noted then (and reiterated in January), 'weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.'

"These FOMC statements held another extremely important message: 'The focus of policy going forward will be to support the functioning of financial markets and stimulate the economy.' In a speech to the National Press Club on Feb. 18, Federal Reserve Chairman Ben Bernanke elaborated:"

'Extraordinary times call for extraordinary measures. Responding to the very difficult economic and financial challenges we face, the Federal Reserve has gone beyond traditional monetary policy making to develop new policy tools to address the dysfunctions in the nation's credit markets.'

"One way to view the effects of those credit market dysfunctions is to imagine that someone had placed a series of bricks at strategic points along the segment of rope connecting short-term interest rates to broader market rates. With these bricks in place, it is simply not enough for a central bank to keep snapping short-term interest rates: The bricks—dysfunctions in the markets—will keep the impulse from being transmitted to the interest rates that are directly connected to market outcomes. Thus, a new set of policy instruments is needed, instruments that allow the monetary authority to circumvent blockages in the monetary transmission mechanism."

The "policy instruments" I have in mind, of course, are the pullulating new facilities that have Jim Hamilton worried. But it is worth emphasizing that many of these facilities are motivated by "unusual and exigent circumstances," a point emphasized in the recent Treasury-Federal Reserve statement (which is discussed in some detail by Tim Duy):

"As long as unusual and exigent circumstances persist, the Federal Reserve will continue to use all its tools working closely and cooperatively with the Treasury and other agencies as needed to improve the functioning of credit markets, help prevent the failure of institutions that could cause systemic damage, and to foster the stabilization and repair of the financial system."

How long will those conditions persist? Returning to my EconSouth commentary:

"No set timetable exists, but one would presume that as long as the bricks of market dysfunction are lying around, the tools will be necessary. Eventually, of course, markets will heal, the bricks will crumble, and the stage will be set to a return to business as usual in monetary policy and the economy. The sooner the better, but in the meantime it's helpful to have the tools in hand to start cracking the bricks."

That's my story, and I'm sticking to it.

By David Altig, senior vice president and research director of the Atlanta Fed

Careful with that language

No doubt about it. The decision last week by the Federal Open Market Committee (FOMC) to further expand its balance sheet by up to $1.15 trillion was momentous. But beyond that number, some commentators seem to have suggested that the FOMC took a qualitative leap into quantitative easing (QE):

Feds Use Quantitative Easing

Fed kept its target rate unaltered and intensifies quantitative easing

QE and the US

The last article above comes from BBC News, where it is made clear that the QE theme is associated with the addition of long-dated Treasury securities to the list of assets that the FOMC has specifically asked the folks at the Open Market Desk at the New York Fed to purchase on their behalf:

"We've now had two weeks of quantitative easing in the UK. But as far as the world's concerned, this is Day One. That's because, as of today, the quantitative easers have the US Federal Reserve on their team.

"The US central bank's announcement yesterday that it would start buying US long-dated Treasury bills as part of a nearly $1.2 trillion stimulus programme came as a shock."

OK, let's repeat. Like any balance sheet, the Federal Reserve's has two pieces, the liability side and the asset side. The FOMC statement was explicitly about the asset side—the quantity and types of assets the Fed intends to purchase. Quantitative easing, on the other hand, is about the liability side. As reader Fischer points out in a comment to our previous macroblog post on the Bank of England's balance sheet:

"The entire point of quantitative easing is to put assets into the economy that increase the money supply..."

That exact point was made by Chairman Bernanke back in January:

"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach—which could be described as 'credit easing'—resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental."

Of course, some think that such "incidental" expansions are far from trivial. John Taylor, for one, has a different view (registration may be required to see full article):

"An explosion of money is the main reason, but not the only one, to be concerned about last week's surprise decision by the Federal Reserve to increase sharply its holdings of mortgage backed securities and to start purchasing longer term Treasury securities."

I don't think anyone should be dismissive of that concern, which makes item 3 of yesterday's joint statement from the Treasury and Federal Reserve particularly noteworthy:

"3. Need to preserve monetary stability: Actions that the Federal Reserve takes, during this period of unusual and exigent circumstances, in the pursuit of financial stability, such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy as needed to foster maximum sustainable employment and price stability. Treasury has in place a special financing mechanism called the Supplementary Financing Program, which helps the Federal Reserve manage its balance sheet. In addition, the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves."

Let us be clear: We are not trying to characterize the recent Federal Reserve decision one way or another. But as the Bank of England's current strategy and the Federal Reserve Chairman's comments noted above clearly indicate, expansions of the asset side of central bank's balance sheet—"credit policy," if you will—are conceptually, and if sterilized operationally, distinct from quantitative easing. The public discussion will be greatly enhanced if we keep those distinctions at the forefront.

David Altig, senior vice president and research director at the Atlanta Fed, and Daniel Littman, economist at the Cleveland Fed

Contraction, not tightening

Over at Financial Crisis and Recession, Susan Woodward and Robert Hall start a recent post, titled "The Fed contracts," with this:

"The Fed has indicated that it plans to pursue a policy of quantitative easing, that is, expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments…

"But... the Fed has engaged in quantitative tightening over the past month, reducing its borrowing and reducing its holding of higher-yielding investments…. So far, no explanation for the Fed's announcements of moving in an expansionary direction while actually contracting."

First, it is probably appropriate to point out that the use of the term "quantitative easing" is a bit out of synch with the policy approach embraced by "the Fed." This is from Chairman Bernanke's January 13 Stamp Lecture at the London School of Economics:

"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach—which could be described as 'credit easing'—resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental… In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."

At Economist's View, Tim Duy zeroed right in on the point:

"Woodward and Hall are confused because they do not recognize that the Fed has not initiated a policy of quantitative easing…because the Fed sees their actions as credit market related, they would have no problem with the balance sheet contracting if credit market conditions dictate."

What Woodward and Hall describe is credit easing in the Bernanke lexicon, as "expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments" is a description of changes in the composition of Federal Reserve assets. But the intent they assume is that of quantitative easing—which in the end is all about expanding the size of the balance sheet (on the liability size specifically).

In our opinion—and we rush here to add that is only our opinion—the key to unwinding the Woodward-Hall "puzzle" is in the last sentence of the Bernanke quotation above: "the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."

It is instructive to examine the source of the recent reduction in the Fed's balance sheet.

Though several categories of Fed assets have declined in recent weeks, the really large changes have been in currency swaps and the Commercial Paper Funding Facility or CPFF. In simple terms, currency swaps are the provision of dollars to foreign central banks to help satisfy dollar-based liquidity needs in foreign financial markets, the CPFF is a Federal Reserve funding facility to assist in the functioning of domestic commercial paper markets.

As the Chairman suggested in his Stamp Lecture:

"…when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities."

At least in U.S. dollar interbank lending markets, liquidity pressures have abated, as LIBOR rates have fallen substantially since last fall and have held relatively steady in recent weeks, and term financing premia have similarly eased.

Commercial paper yield spreads have also narrowed considerably for both asset-backed and financial paper since the introduction of the CPFF last fall:

Interestingly, a large amount of maturing CPFF paper was not reissued into the CPFF or the market in late January. This decline could be a result of some borrowers shifting to other, cheaper sources of credit. From CNNMoney:

"The Fed's commercial paper funding facility was a popular alternative for cash-strapped corporations at the height of the credit crunch, but demand for funding through the program has waned. Another government sponsored program, the FDIC's Temporary Liquidity Guarantee Program backs financial institution debt issued up to 10 years, a more attractive alternative for many companies."

There is one additional wrinkle. Agency mortgage-backed securities—which the FOMC has authorized the purchase of, up to $500 billion—show up on the balance sheet at the time the trades settle. As of February 4, the Fed's balance sheet has $7.4 billion in Agency MBS. However, if you sum the purchases that the NY Fed posts on their Web site, the total is closer to $92 billion so far. Thus, roughly $85 billion in MBS the Fed has purchased have yet to show up on the balance sheet because the trades haven't settled. (Hat tip to our colleague Mike Hammill for bringing this to our attention.)

The central bank's balance sheet is in fact contracting. Maybe. But is it policy tightening? Doubtful.

By David Altig, senior vice president and research director, and John Robertson, vice president and senior economist at the Atlanta Fed

What, exactly, is the Fed trying to do?

There has been, of late, no shortage of official voices devoted to answering the question posed in the title of this post. Chicago Fed President Charles Evans, San Francisco Fed President Janet Yellen, Richmond Fed President Jeff Lacker, Philadelphia Fed President Charles Plosser, and Chairman Bernanke have all given speeches in the last two weeks outlining their version of answers to this question. Add to that list Federal Reserve Bank of Atlanta President Dennis Lockhart, who laid out his own views at a speech to the Atlanta Rotary Club this past Monday and again today at the University of Southern Mississippi's Outlook for South Mississippi Conference. Here's what he said:

"The Fed, as the country's central bank, conducts monetary policy—as distinct from fiscal policy—under legal mandates set down by Congress. The Fed's mandated policy objectives—the so-called dual mandate—are sustainable economic growth along with low and stable inflation.

"The mandates have not changed. But what has changed is some aspects of how we pursue those objectives. Extraordinary circumstances this last year and a half have required the Fed to expand the set of tools employed to meet those objectives."

What is the practical implication of those circumstances?

"The federal funds rate is a very general tool and one that relies on the functioning of credit markets to have its intended effects. But, as you know, credit markets have not been functioning normally even in markets strongly backed by the U.S. government, such as agency (e.g., Fannie Mae and Freddie Mac) mortgage-backed securities….

"Among the programs in force is the direct purchase of agency (Fannie Mae, Freddie Mac, etc.) notes and mortgage-backed securities. These securities are directly linked to mortgage rates. Purchases began just a few days ago. The goal of such a program is not, in my view, to engineer a particular interest rate level, that is, to hit a particular rate target. But direct purchases can promote directionally lower rates, help restore normal market functioning, and thereby achieve a return to reliance on private sector market-based credit allocation.

"The introduction of targeted asset-side measures has been aimed squarely at the breakdown of credit markets, the circulatory system of our modern economy. In my view, a precondition of economic recovery is the return of the normal functioning of credit markets."

Sometimes, if I may paraphrase, deviating from business as usual is the best way back to business as usual.

President Lockhart's Speech
Speech Q&A
From the Atlanta Fed Speeches podcast series

By David Altig, senior vice president and research director at the Atlanta Fed

On expanding balance sheets and inflationary policy

Here's a question I hear a lot (most recently during the Q&A portion of a speech delivered yesterday by my boss, Atlanta Fed president Dennis Lockhart): Has monetary policy become so expansive that the central bank's mandate to maintain price stability has been fundamentally compromised? Is the increase in the scale of the Federal Reserve's balance sheet inherently inflationary?

Jim Hamilton covered much of the territory implied by these questions in a very extensive Econbrowser post not too long ago, but the distinction between money creation and Fed balance sheet expansion continues to be confounded. Here, for example, is a passage from the Wall Street Journal's Real Time Economics coverage of Stanford professor John Taylor's (not exactly glowing) review of recent Federal Reserve action, delivered at this year's annual meeting of the American Economic Association:

"The Fed has launched nearly a dozen new programs in the past year to address the crisis. Its strategy is to target specific markets in distress—from commercial paper to asset backed securities to money market mutual funds and stresses overseas—with programs tailored to their problems. It also has gotten deeply involved in rescues of individual firms like Bear Stearns, American International Group and Citigroup.

"The Fed has funded these programs by pumping reserves into the banking system—essentially creating new money. In the process, its balance sheet has ballooned from less than $900 billion to more than $2 trillion."

The record though, as the article goes on to note, is that not all of that $2 trillion represents an increase in the money supply:

Only the blue portion of the graph above represents "pumping reserves into the banking system"—a fact that was covered pretty well in the aforementioned Econbrowser post—and in an even earlier post at News N Economics. In simple terms, the size of the Fed's balance sheet is not the same thing as the size of the monetary base (the sum of currency in circulation and reserve balances kept by banks with the Federal Reserve).

Of course, John Taylor's point was not that all of the increase in the balance sheet has amounted to pumping in reserves, just that a lot of it has, which is clearly true. But even here there may be less to the potential inflationary impact than meets the eye. In his speech at the London School of Economics earlier today, Chairman Bernanke explained:

"Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary. The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base."

Last week Greg Mankiw had a nifty graph (courtesy of Professor Bill Seyfried of Rollins College) of the so-called money multiplier precisely illustrating the point:

The money multiplier measures the amount of money in the hands of the public—the M1 measure in this case, which is composed mainly of cash and demand deposits (i.e., checking and debit accounts)—that are created by a dollar of monetary base. That amount fell considerably when the Fed introduced the payment of interest on bank reserves.

That said, despite the fall in the money multiplier, the M1 measure of money has also expanded fairly noticeably since late summer:

(Note: This chart replaces the original chart in the blog posting on 1/13/09, which had a mislabeled left axis.)

The increase in M2—a slightly broader measure of money that adds to M1 items like savings accounts and time deposits—has been somewhat slower but still on the rise:

(Note: This chart replaces the original chart in the blog posting on 1/13/09, which had a mislabeled left axis.)

From December 2007 through August of last year, M1 and M2 grew by about 1.2 percent and 3.9 percent respectively. Since September—after which the rapid expansion of the Fed's balance sheet began and the Fed began to pay interest on reserves—the corresponding growth rates have been 13.4 percent and 5.9 percent.

Are those growth rates substantial? That is a tricky question—whether a particular growth rate of money is substantial or not can only be determined in relation to the pace of money demand (which has almost certainly accelerated as interest rates have fallen and the taste for safe and liquid assets risen). But I take two lessons from our early experience with the asset-oriented policies emphasized in the Bernanke and Lockhart speeches. First, expansions of the balance sheet need not imply expansions of the money supply. Furthermore, as Chairman Bernanke emphasized, the Fed has the capacity to contract reserves going forward:

"… the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system."

The second lesson, clear in the M1 and M2 charts above, is that despite the payment of interest on reserves and near-zero federal funds rates, it is still possible to induce increases in the broad money supply through the standard channel of injecting reserves into the banking system.

Whatever direction you think the money supply ought to go, these observations should come as comforting news.

By David Altig, senior vice president and research director at the Atlanta Fed