Jerome H Powell: Thoughts on unconventional monetary policy
Speech by Mr Jerome H Powell, Member of the Board of Governors of the Federal Reserve
System, at the Bipartisan Policy Center, Washington DC, 27 June 2013.
* * *
Views expressed in this speech are mine and may not represent those of the FOMC or any of its members. I
would like to thank members of the Board staff, including James Clouse, Dan Covitz, Jon Faust, John Maggs,
Raven Molloy, Karen Pence, Jeremy Rudd, and Brad Strum.
It is great to be back at the Bipartisan Policy Center. I will comment briefly on the outlook for
the economy and then turn to monetary policy.
Near-term outlook
Our economy has grown at an average annual rate of only about 2 percent since the
recovery began exactly four years ago. That modest pace is notably weaker than the
experience of past recoveries would have predicted, even accounting for the depth and
duration of the Great Recession.1 Since 2009, the question has been when the recovery will
decisively take hold and begin to deliver the higher levels of growth that are needed to put
people back to work more quickly.
Against that background, the Federal Open Market Committee (FOMC) met last week, and,
among other tasks, each of the 19 members of the Committee submitted individual economic
projections for growth, unemployment, and inflation for 2013 through 2015. These forecasts
are combined into the Summary of Economic Projections (SEP), a high-level outline of which
was released at the Chairman's press conference last week. FOMC participants generally
expect an acceleration of the recovery through 2013 and 2014 and continued strong growth
in 2015. While I make no claim to special forecasting skills, my individual projections are
within the so-called central tendency of the projections. Of course, the economy has looked
to be poised for a breakout several times since 2009, only to disappoint. Will this time be
different?
There are, in my view, good reasons to believe that the economy will continue to gain
strength. I would point in particular to the housing sector, which in prior recoveries has been
an important engine of growth. For the first two years of the current recovery, housing
contributed nothing to growth, as housing investment hovered at extremely low levels. House
prices declined sharply through most of 2011, wiping out about half of home equity and
restraining consumer spending. But the housing market finally began to recover in early
2012, and that recovery seems to be proceeding strongly. Single-family housing starts have
risen by more than 40 percent over the past two years, albeit from a low base. House prices
are up more than 10 percent over the past 12 months. A better housing market has helped
boost consumer attitudes from very low levels and supported consumer spending. The
housing sector is still being held back by limited credit availability for less-creditworthy
homebuyers and tight conditions for homebuilders. But overall trends suggest to me that the
housing recovery can continue for many years and become an important contributor to
growth.
The labor market has also made real progress, as I will discuss in a moment. Auto sales
have nearly returned to pre-recession levels. Our financial system is far healthier and better
capitalized than it was before the crisis. And after losing one-half of its value during the
financial crisis, the stock market now exceeds its pre-recession peak in nominal terms.
Growth would be higher this year but for U.S. fiscal policy. The Congressional Budget Office
(CBO) estimates that federal tax increases and spending cuts will slow the pace of real gross
domestic product (GDP) growth about 1-1/2 percentage points this year.2 Tight fiscal policy
may also be preventing faster reductions in unemployment. I have been surprised by how
well consumer spending - and private domestic final demand more generally - have held up
in the face of this pronounced fiscal drag. In the first quarter of this year, consumer spending
and private domestic final demand rose at an annual rate of just above 2-1/2 percent.
Morerecent indicators of household and business spending suggest that private demand is
continuing to advance at a reasonable clip despite the fiscal tightening. This strength is a
reason for optimism. Indeed, even if real GDP rises only 2 percent or so this year-which is
at the bottom end of the range of projections from the June SEP-it would still represent a
solid performance in the face of these fiscal headwinds.
There is still a long way to go before we achieve a full recovery. The healing process will take
time, but we continue to make real progress.
Let's turn to monetary policy, starting with the dual mandate, pursuant to which the Congress
directs the Federal Reserve to conduct monetary policy so as to foster stable prices and full
employment.
Dual mandate - inflation
Inflation is currently running below the FOMC's 2 percent long-term objective for personal
consumption expenditure (PCE) price inflation, and these readings have our attention. But
inflation often fluctuates for transitory reasons. We generally try to look through such
transitory movements, whether above or below our objective. There is some reason to think
that the recent low readings partly reflect transitory factors. Other factors point to a gradual
increase in inflation. While some measures of longer-term inflation expectations have moved
down, others remain more stable. Most FOMC participants anticipate that inflation will
gradually move up to the FOMC's 2 percent target over coming years. Continued low or
falling inflation could, however, raise real concerns. Inflation can be too low as well as too
high. I have no doubt that the Committee will monitor this carefully and defend the inflation
goal "from below," if necessary.
Dual mandate - full employment
The employment side of the dual mandate is a different story. From payroll employment's
peak in January 2008 to its trough in February 2010, the U.S. economy lost nearly 9 million
jobs, while the unemployment rate rose from an average of about 4-1/2 percent in 2007 to a
high of 10 percent in October of 2009. As the economy has recovered, we have regained
only about three-fourths of those lost jobs. Unemployment was 7.6 percent in May and so
has come down about 2-1/2 percentage points from its peak. A broader measure that
includes those who can only find part-time work, as well as those who want a job but have
stopped looking, was 13.8 percent last month; in 2007, this measure averaged
8-1/4 percent.
In addition, long-term unemployment remains very high - 4.4 million Americans or about
37 percent of the unemployed have been out of work for six months or more. These numbers
represent tragedy and hardship for these workers and their families, of course, but they also
represent a crucial economic challenge. The longer workers are unemployed, the greater the
likelihood that their skills will erode and workers will lose attachment to the labor force,
permanently damaging the economy's dynamism and potential output.
To summarize, although inflation is below target, it is expected by most observers to return
over time to the Committee's 2 percent objective. The Committee will continue to carefully
monitor inflation developments. But we are still far from full employment. The case for
continued support for the economy from monetary policy is strong.
Implications for monetary policy
The federal funds rate has been near zero since late 2008, and since then the FOMC has
been providing accommodation through two relatively new policy tools. These tools are
"forward guidance" about the future level of the federal funds rate, which is the interest rate
charged on overnight loans between banks, and large-scale asset purchase programs
("asset purchases," or LSAPs).
In part, the forward-guidance tool is embodied in the thresholds the FOMC adopted last
December. The Committee indicated its intention to hold short-term rates near zero at least
as long as unemployment remains above 6.5 percent, provided inflation one- to two-years
ahead is projected to be no higher than 2.5 percent.4 3And under the current flow-based
LSAP program, adopted last year, we are purchasing $85 billion a month in long-term
Treasury securities and agency mortgage-backed securities (MBS). Although the level of
purchases may vary depending on economic conditions, the program will continue until there
is a substantial improvement in the outlook for the labor market, in a context of price stability.
I see the first tool, forward guidance about rates, as really an extension of traditional central
bank rate-setting policy. By stating an intention to hold rates low and linking that intention to
the path of the economy, forward guidance affects the path of longer-term rates and allows
the market to make adjustments to these rates as economic conditions evolve.
The second tool is large-scale asset purchases. By purchasing and holding large amounts of
Treasury securities and MBS, we put additional downward pressure on term premiums and
so on long-term rates. Asset purchases are an innovative, unconventional policy. Their likely
benefits may be accompanied by costs and risks, the nature and size of which remain
uncertain.
These two policies are complementary but play somewhat different roles. Asset purchases
are being deployed to add near-term momentum to the economy. After those purchases are
eventually completed, the purchased assets will remain on the Fed's balance sheet for some
time and continue to put downward pressure on rates. The Committee will continue to use
interest rate policy, including forward guidance about short-term rates, as we return to full
employment. Provided inflation remains in check, the Committee will begin to assess
whether to increase short-term rates when unemployment reaches 6.5 percent. Two
important considerations are likely to arise at that time. First, if inflation remains low, as
expected, that would be a signal that there is still significant slack in the economy. Second, a
variety of other information will shed further light on the health of the labor market, including
the labor force participation rate, flows into and out of employment, and other measures of
labor slack. After the Committee first raises short-term rates, it will take a balanced, and in all
likelihood gradual, approach consistent with its longer-run goals of full employment and
inflation of 2 percent.
Both forward guidance and asset purchases work by lowering longer-term interest rates and
contributing to an easing of overall financial market conditions. Lower rates increase
economic activity through a variety of channels.4 Businesses and households react to lower
rates by investing and spending more. Lower rates also support the prices of housing and
financial assets such as stocks and bonds. Higher asset prices increase wealth and, with a
lag, induce higher spending.
In all likelihood, the current LSAP program will continue for some time. It is therefore
appropriate to ask how well asset purchases have worked, and whether they are still working
today.
Benefits
Most research has found, and I agree, that the first round of purchases of longer-term
securities, which began in November 2008, contributed significantly to ending the financial
crisis and preventing a much more severe economic contraction. The second round of
purchases that began in November 2010 also appears to have been successful in countering
disinflationary pressures.5
Now that the financial crisis has receded and the economy is recovering at a moderate pace,
are asset purchases still effective? In my view, the evidence across the channels is mixed,
but positive on balance.
Economic models are used to provide a necessarily uncertain estimate of the effect on the
economy of the FOMC's asset purchases. The Fed's workhorse macro model is FRB/US,
which estimates a reduction of about 20 basis points in the unemployment rate after three
years in the wake of $500 billion in purchases of longer-term securities. There are reasons to
think that this estimate may be too low; for example, FRB/US does not include any direct
channel for LSAPs to boost house prices. There are also reasons to think that the estimate
might be too high, since some of the channels by which lower rates spur economic activity
could be attenuated in current circumstances, for example, by lower credit availability for
small businesses and less creditworthy households, or corporate and household risk
aversion.
My view is that the LSAPs continue to provide meaningful support for economic activity but
perhaps less than what the FRB/US estimates suggest. Although the channels may not be
working perfectly, it is unlikely that they are not working at all. Beyond these model-predicted
effects, it also seems likely that the economy continues to benefit from the knowledge that
the Federal Reserve is committed to supporting growth as long as necessary.
4
See Jonathan McCarthy (2013), "The Monetary Transmission Mechanism," speech delivered at "The Federal
Reserve in the 21st Century: A Symposium for College Professors," held in New York, March 4-5.
5
See Canlin Li and Min Wei (2012), "Term Structure Modelling with Supply Factors and the Federal Reserve's
Large Scale Asset Purchase Programs," Finance and Economics Discussion Series 2012-37 (Washington:
Board of Governors of the Federal Reserve System, May); Arvind Krishnamurthy and Annette
VissingJørgensen (2011), "The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy
Brookings Papers on Economic
(PDF)," Activity, Fall, pp. 215-65; Stefania D'Amico, William English, David
López-Salido, and Edward Nelson (2012), "The Federal Reserve's Large-Scale Asset Purchase Programmes:
Rationale and Effects," Economic Journal, vol. 122 (November), pp. F415-F446; James D. Hamilton and Jing
Cynthia Wu (2012), "The Effectiveness of Alternative Policy Tools in a Zero Lower Bound Environment,"
Journal of Money, Credit and Banking, vol. 44 (February supplement), pp. 3-46; Diana Hancock and Wayne
Passmore (2012), "The Federal Reserve's Portfolio and its Effects on Mortgage Markets," Finance and
Economic Discussion Series 2012-22 (Washington: Board of Governors of the Federal Reserve System,
June); and Carlo Rosa (2012), "How "Unconventional" Are Large-Scale Asset Purchases? The Impact of
Monetary Policy on Asset Prices," Federal Reserve Bank of New York Staff Reports 560 (New York: Federal
Reserve Bank of New York, May).
Costs of LSAPs
What of the potential costs or risks of the asset purchases? A variety of concerns have been
raised over time. With inflation in check, the most important potential risk, in my view, is that
of financial instability. One concern is that our policies might drive excessive risk-taking or
create bubbles in financial assets or housing. A related worry is that the eventual process of
reducing purchases and normalizing the balance sheet may itself be destabilizing or
disruptive to the economy. Indeed, recent volatility in markets is in part related to concerns
about the possibility of a reduction in asset purchases. I'll address both of these broad
concerns, starting with incentives for risk-taking.
Monetary policy has helped to keep real interest rates low. While longer-term real rates have
turned positive in recent weeks, they remain at historically low levels. Experience suggests
that low real rates, if maintained for a long time, can lead to asset price bubbles and
eventually to financial instability. But low rates are not solely or even primarily a result of the
Federal Reserve's accommodative monetary policies; they are rooted in the market's
expectations of low inflation and the weakness of the economic recovery, factors weighing on
rates not just in the United States but throughout the advanced economies.6 Given low real
rates and low inflation, expected nominal returns should be low across all asset classes. The
concern would be that these conditions, and our policies, could be encouraging irrational
expectations of high returns. Is there any sign of that now?
By most measures, equity valuations seem to be within a normal range. Whether one looks
at trailing or forward price-to-earnings ratios, equity risk premiums, or option prices, there is
little basis for arguing that markets show excessive optimism about future returns. Of course,
in the equity markets there is always downside risk.
But, as my Board colleague Jeremy Stein has observed, there have been signs of a "reach
for yield" in the fixed-income markets for some time.7 Demand for higher-yielding
fixedincome securities has outstripped new supply. The result has been very low rates, declining
spreads, increasing leverage, and pressure on non-price terms such as covenants. These
concerns have diminished somewhat as rates have risen since mid-May. Nonetheless, since
it is likely that asset purchases will continue for some time, markets will need careful
monitoring.
What about house prices? At the peak of the bubble, house prices were more than
40 percent above their usual relationship to rents, according to one model that the Fed staff
follows. At their trough, house prices had fallen about 10 percent below fair valuation. Given
the price increases over the past year, they are - by the lights of this one model - moving
back into the approximate neighborhood of fair valuation.
The second concern is that the process of normalizing monetary policy and the balance
sheet could itself be destabilizing or disruptive to the economy. Many cite the experiences of
1994 and 2003, when long-term rates increased quite sharply on changing views about the
likely near-term path of policy. In those instances, there were both changes in views about
the economy and changes in the public's understanding of the Federal Reserve's policy
intentions. These same two factors have affected markets in recent weeks.
Market adjustments since May have been larger than would be justified by any reasonable
reassessment of the path of policy. In particular, the reaction of the forward and futures
markets for short-term rates appears out of keeping with my assessment of the Committee's
intentions, given its forecasts. The June SEP shows that 15 of 19 participants see the first
rate increase happening in 2015 or 2016. The path of rates will ultimately depend on the path
of the economy, and the Committee has said that the first rate increase will not happen until
a considerable time has elapsed after asset purchases have been concluded. Thus, to the
extent the market is pricing in an increase in the federal funds rate in 2014, that implies a
stronger economic performance than is forecast either by most FOMC participants or by
private forecasters.
We have made significant strides in communication in recent years. The unemployment and
inflation thresholds I discussed earlier, as well as the communication around asset
purchases, are all designed to improve public understanding of the Committee's intentions.
But communications are bound to be imperfect, and changes in the outlook can still lead to
adjustments in asset prices. Thus, some volatility is unavoidable, and indeed is a necessary
part of the process by which markets and the economy adjust to incoming information.
The path ahead for monetary policy
Last week, the Chairman provided greater clarity about the path of asset purchases.
Specifically, the Chairman noted that, if incoming data are broadly consistent with the
Committee's sense of the economic outlook, the Committee currently anticipates that it would
be appropriate to moderate the monthly pace of purchases later this year. If the subsequent
data remain broadly aligned with the Committee's current expectations for the economy, the
Committee could continue to reduce the pace of purchases in measured steps through the
first half of next year, ending purchases around mid-year. At that time, the unemployment
rate would likely be in the vicinity of 7 percent, with growth consistent with further
improvements and inflation heading back toward our objective. If unemployment reaches the
7 percent range, that would constitute a substantial improvement from the 8.1 percent
unemployment rate that prevailed when the Committee announced the current program of
asset purchases.
I want to emphasize the importance of data over date. If the Committee's economic outlook
is broadly realized, there will likely be a moderation in the pace of purchases later this year. If
the performance of the economy is weaker, the Committee may delay before moderating
purchases or even increase them. If the economy strengthens faster than the Committee
anticipates, the pace of purchases may be moderated somewhat more quickly. The path of
purchases is in no way predetermined; we will monitor economic data and adjust our
purchases as appropriate.
In my view, there has been real progress in the labor market. The Committee first adopted
the "substantial improvement" test at the September 2012 meeting, so it is appropriate to
measure the economy's progress against economic conditions at that time. When the
Committee met in September, the unemployment rate stood at 8.1 percent. Today, just nine
months later, the unemployment rate is 7.6 percent - a larger decline than most FOMC
participants expected in September. At the time of the September meeting, nonfarm payrolls
were reported to have increased at a monthly rate of 97,000 over the prior six months.8
Today the trailing six-month average payroll growth is 194,000. Other labor market indicators
also show moderate progress, including aggregate hours worked, initial unemployment
insurance claims, the duration of unemployment, and the share of long-term unemployment.
Conclusion
There are many signs that the economy is healing. If the Committee's economic outlook is
broadly realized, and we do see the first moderation in the pace of purchases later this year,
that would be good news. The first reduction in purchases, when it comes, will be an
acknowledgement of the economy's progress and a sign of the Committee's confidence in
the path to full recovery.
In all cases, the path of policy will remain fully data-dependent. If economic growth,
unemployment, or inflation do not meet the Committee's expectations, or if financial
conditions evolve in a way that is inconsistent with continued recovery, the Committee will
respond.
Thanks, and I am happy to take your questions.