Janet L Yellen: Unconventional monetary policy and central bank
communications
Speech by Ms Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the University of Chicago Booth School of Business US Monetary Policy Forum,
New York, 25 February 2011.
* * *
The U.S. Monetary Policy Forum has become an important venue for promoting an
exchange of views among policymakers, academics, and financial market participants. I'm
pleased to participate in this panel on lessons learned about unconventional monetary policy.
In my remarks today, I'll highlight the role of central bank communications in bolstering the
effectiveness of unconventional monetary policy.1 It is not my intention to provide new
information about the outlook for the U.S. economy or monetary policy.
The Federal Open Market Committee (FOMC) has deployed unconventional monetary policy
tools to promote economic recovery and price stability since late 2008. In particular, after the
intensification of the financial crisis, conventional monetary policy became constrained by the
zero lower bound on nominal interest rates. At that point, the FOMC began to provide
forward guidance about the likely path of the federal funds rate, and the Federal Reserve
also announced a program to buy agency debt and mortgage-backed securities (MBS). Over
time, the purchase program was augmented substantially and was expanded to include
longer-term Treasury securities. Furthermore, on several occasions, the FOMC has
communicated to the markets about the likely longer-term trajectory of its holdings of
Treasury securities, agency debt, and agency MBS.
In the remainder of my remarks, I will present some evidence regarding the effectiveness of
these policy tools and discuss important similarities and differences in the transmission
mechanisms through which they influence the economy. I will also present some simulations
of a macroeconometric model to illustrate the importance of clear and effective
communication in conjunction with the use of these unconventional policy tools.
Some general observations
It is important to recognize at the outset that conventional and unconventional monetary
policy actions bear many similarities. Forward guidance concerning the path of the federal
funds rate, for example, is explicitly intended to influence market expectations concerning the
future trajectory of shorter-term interest rates and thereby affect longer-term interest rates.
That said, standard monetary policy actions also typically alter not just current short-term
rates, but the anticipated path of short-term rates as well, influencing longer-term rates
through the identical channel. In fact, central bankers have long recognized that this
"expectations channel" operates most effectively when the public understands how
policymakers expect economic conditions and monetary policy to evolve over time, and how
the central bank would respond to any changes in the outlook.
The transmission channels through which longer-term securities purchases and conventional
monetary policy affect economic conditions are also quite similar, though not identical. In
particular, central bank purchases of longer-term securities work through a portfolio balance
channel to depress term premiums and longer-term interest rates. The theoretical rationale
for the view that longer-term yields should be directly linked to the outstanding quantity of
longer-term assets in the hands of the public dates back at least to the 1950s.2
Each of these policy tools tends to generate spillovers to other financial markets, such as
boosting stock prices and putting moderate downward pressure on the foreign exchange
value of the dollar. My reading of the evidence, which I will briefly review, is that both
unconventional policy tools - the use of forward guidance and the purchases of longer-term
securities - have proven effective in easing financial conditions and hence have helped
mitigate the constraint associated with the zero lower bound on the federal funds rate.
The effectiveness of forward guidance
I will begin with an assessment of the FOMC's forward guidance concerning the federal
funds rate, which began when the FOMC reduced its funds rate target to a range of 0 to
1⁄4 percentage point. In particular, the December 2008 FOMC meeting statement indicated
that "economic conditions are likely to warrant exceptionally low levels of the federal funds
rate for some time." Identical guidance was reiterated in January 2009, and in March 2009
the phrase "for some time" was changed to "for an extended period."
Figure 1 suggests that the provision of guidance concerning the future path of the federal
funds rate likely contributed to more accommodative financial market conditions. In
particular, the consensus outlook of professional forecasters regarding the path of the funds
rate shifted down markedly in the Blue Chip survey published at the beginning of February
2009 (the solid line) compared with the survey published two months earlier (the dashed
line).3
A crucial feature of the FOMC's policy communications is that the Committee's forward
guidance has been framed not as an unconditional commitment to a specific federal funds
rate path, but rather as an expectation that is explicitly contingent on economic conditions.
Since November 2009, the Committee has specifically indicated that the relevant economic
conditions include "low rates of resource utilization, subdued inflation trends, and stable
inflation expectations." An important consequence of such conditionality, serving to enhance
the effectiveness of the guidance, is that incoming information about economic and financial
developments has led forecasters and investors to revise their outlook for the path of the
funds rate even in the absence of a change in the forward guidance language.
The evolution of financial market expectations concerning the funds rate path over the past
year illustrates that the conditional nature of the FOMC's forward guidance allows incoming
economic data to shift market views. For example, as shown in the left panel of figure 2, the
expected path of the funds rate shifted down markedly during the spring and early summer of
last year in the wake of weaker readings on economic activity and prices and of some
concerns about potential spillovers from developments in Europe. Those expectations shifted
down somewhat further during late summer and early autumn. Conversely, as shown in the
right panel, funds rate expectations have shifted upward over the past several months in
response to more-positive economic news and greater confidence that a self-sustaining
economic recovery may be taking hold.
Down the road, once the recovery is well established and the appropriate time for beginning
to firm the stance of policy appears to be drawing near, the FOMC will naturally need to
adjust its "extended period" guidance and develop an alternative communications strategy to
shape market expectations about the policy outlook. However, if there were an unexpected
faltering of the recovery or a substantial widening of downside risks to economic activity and
inflation, the forward guidance now in place might well be sufficient to facilitate an outward
shift in the expected path of the funds rate, just as we saw over the course of last year.
If financial market participants appeared to be expecting policy firming to begin somewhat
sooner than policymakers considered desirable or appropriate under such circumstances,
the language of the forward guidance could be adjusted to shift expectations toward the
somewhat longer horizon over which the Committee expected the federal funds rate to
remain extraordinarily low. Figure 3 illustrates the potential for such a change in forward
guidance to support economic activity. In the left panel, the dashed line denotes the baseline
path for the federal funds rate as embedded in current financial market data, while the solid
line corresponds to an alternative path in which the initiation of policy firming is postponed by
one year. If policymakers viewed that alternative path as appropriate and market participants
came to share that view, then financial conditions would become significantly more
accommodative, even in the absence of any change in the current level of the funds rate. As
shown in the right panel, a simulation of the FRB/US model - a macroeconometric model
developed and maintained at the Federal Reserve Board - indicates that such a shift in
policy expectations would be associated with a lower trajectory for the unemployment rate
(solid line) and a somewhat higher path of core inflation (dashed line) over coming years.
The effectiveness of asset purchases
I will now turn to an assessment of the FOMC's program of longer-term securities purchases.
Both theory and empirical evidence suggest that asset prices and yields are affected not only
by current securities purchases but also, importantly, by market expectations concerning
future FOMC securities holdings. This observation implies that central bank communications
pertaining to any important feature of the path of the Federal Reserve's balance sheet should
influence financial conditions.
Event studies can therefore be helpful in gauging the financial market effects of such
communications.4 For example, table 1 reports the response of selected financial variables
on several key dates associated with the FOMC's purchases of longer-term securities. In late
November 2008, the Federal Reserve announced that it would purchase up to $600 billion in
agency MBS and agency debt, and Chairman Bernanke provided further details in a speech
one week later. On March 18, 2009, the FOMC announced that the program would be
expanded by an additional $850 billion in purchases of agency securities and by $300 billion
in purchases of longer-term Treasury securities. Evidently, each of those communications
was associated with substantial declines in longer-term nominal and real Treasury yields and
in rates on agency MBS and corporate debt.
Last August, the FOMC announced that it would begin reinvesting principal payments on
agency MBS and agency debt into longer-term Treasury securities, and over the subsequent
couple of months or so, the public remarks of Federal Reserve officials made note of the
possibility of a further expansion of the portfolio. Consequently, when the Committee
announced in early November that it intended to purchase an additional $600 billion in
longer-term Treasury securities, that decision was largely anticipated by financial market
participants, and it occasioned only minimal market response. However, taken together the
movements in longer-term interest rates that occurred between the August and November
FOMC meetings are strikingly similar to those on the prior announcement dates shown in the
table, bolstering the judgment that these securities purchases contribute to more
accommodative financial conditions.
One complication that arises in evaluating the contribution of portfolio balance effects to the
observed movements in longer-term rates is that news about large-scale asset purchases
may also influence investors' perceptions regarding the likely path of short-term interest
rates. Such effects may not have been very important, however, when the FOMC announced
the expansion of its securities purchases in March 2009. As shown in Figure 4, that
announcement appeared to have only modest effects on the outlook of professional
forecasters (left panel) and investors (right panel) regarding the likely trajectory of the federal
funds rate. Thus, the substantial decline in longer-term yields following this announcement
appears to have mainly reflected the effect of the purchases in pushing down term premiums
rather than a shift in the expected path of the funds rate.5 This evidence suggests that the
portfolio balance channel of influence is not only operative but also fairly large.
That said, as we saw in figure 2, the expected path of the federal funds rate does appear to
have flattened for a time during the late summer and early autumn of last year. Even allowing
for that change in near-term policy expectations, however, it seems reasonable to conclude
that the announcement of additional securities purchases mainly affected financial conditions
through the portfolio balance channel.
To assess the macroeconomic effects of the Fed's large-scale asset purchase program, I
would like to highlight some findings from a recent study by four Federal Reserve System
economists.6 As shown in figure 5, the authors constructed an illustrative baseline trajectory
for the Federal Reserve's securities holdings over the course of this decade (solid line) as
well as an alternative trajectory corresponding to a counterfactual scenario in which the
FOMC never decided to initiate any securities purchases (dashed line).
The baseline incorporates the first round of asset purchases - which brought the Federal
Reserve's securities holdings to a little more than $2 trillion. It embeds an assumption that
the FOMC will complete the purchases announced last November so that the balance sheet
expands to about $2.6 trillion by the middle of this year. From that point forward, the authors
assume that the overall size of the portfolio will remain unchanged until mid-2012 and then
shrink gradually at a rate sufficient to return it to its pre-crisis trend line by mid-2016,
whereupon the Federal Reserve resumes expanding its holdings at the trend rate. Full
composition
convergence of the of the portfolio is not complete until 2017, however, as the
average maturity of the portfolio is still somewhat elevated in 2016. It should also be noted
that the trend line itself rises gradually over time as a consequence of steady growth in
demand for U.S. currency.
Of course, the baseline trajectory is purely illustrative: The actual evolution of the Federal
Reserve's balance sheet will depend on the decisions that the FOMC will make in light of
economic and financial developments. Nonetheless, the overall characteristics of this
assumed trajectory seem broadly consistent with the sense of the Committee's discussions
last spring. In particular, as reported in the minutes of the April 2010 FOMC meeting, most
Committee participants expressed a preference for renormalizing the size and composition of
the Federal Reserve's balance sheet over a period of about five years that would commence
following the initiation of policy firming.
Figure 6 shows the results of simulations of the FRB/US model to gauge the effect of these
asset purchases on the unemployment rate and core personal consumption expenditures
(PCE) inflation. For this purpose, the baseline path (denoted by the dashed line in each
panel) is constructed using historical data in conjunction with the latest set of consensus
projections from the Survey of Professional Forecasters conducted by the Federal Reserve
Bank of Philadelphia. Then the staff model is used to simulate the counterfactual scenario in
which the FOMC never conducts any asset purchases (denoted by the solid line in each
panel).7 The pace of recovery under the baseline scenario is expected to be painfully slow.
But the counterfactual scenario suggests that conditions would have been even worse in the
absence of the Federal Reserve's securities purchases: The unemployment rate would have
remained persistently above 10 percent, and core inflation would have fallen below zero this
year. Of course, considerable uncertainty surrounds those estimates, but they nonetheless
suggest that the benefits of the asset purchase programs probably have been sizeable.
My final observation concerning the FOMC's asset purchase program pertains to the
importance of clear and effective communications in the years ahead. As I noted earlier, both
theory and empirical evidence suggest that market prices and yields at any particular time
reflect both the Federal Reserve's current securities holdings and also markets participants'
expectations for its future holdings. Consequently, a shift in expectations concerning the
trajectory of the Federal Reserve's balance sheet could have an important effect on financial
conditions going forward.
In particular, financial conditions depend on market expectations not only concerning the
amount of the FOMC's purchases but also concerning the anticipated timing and pace of the
eventual unwinding of those holdings. For example, financial conditions would likely tighten
immediately if market participants came to expect a more rapid renormalization of the
Federal Reserve's balance sheet. In contrast, if market participants were to anticipate a more
gradual renormalization, financial conditions would likely become more stimulative.
To illustrate the potential importance of such changes in expectations, figure 7 depicts a
scenario in which markets come to anticipate that the Federal Reserve will shrink its balance
sheet more rapidly than in the baseline scenario. The left panel shows the assumed contour
of an expected acceleration of asset sales that would renormalize the overall size of the
portfolio within about two years (solid line), roughly twice as fast as under the baseline
scenario (dashed line). The announcement of such a strategy would cause a substantial rise
in term premiums relative to the baseline scenario, and, assuming no offsetting change in the
path of the federal funds rate, the resulting higher level of long-term interest rates would
damp aggregate spending. The right panel depicts the macroeconomic effects of the more
rapid runoff of the balance sheet in terms of deviations from the baseline scenario: The
unemployment rate (solid line) is significantly higher, and core PCE inflation (dashed line) is
somewhat lower.
Conclusion
In conclusion, I believe that both forward guidance and large-scale asset purchases have
been effective tools for providing additional monetary accommodation under circumstances
in which conventional monetary policy has been constrained by the zero lower bound on the
federal funds rate. My colleagues on the FOMC and I are regularly reviewing the asset
purchase program in light of incoming information, and we will adjust the program as needed
to promote our statutory mandate of maximum employment and stable prices. Recognizing
the importance of market expectations to the effectiveness of unconventional policies, the
Committee will continue to seek ways to enhance the clarity and effectiveness of our
monetary policy communications.
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