Stanley Fischer: Monetary policy lessons and the way ahead
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the Economic Club of New York, New York City, 23 March 2015.
* * *
For over six years, the federal funds rate has, effectively, been zero. However it is widely
expected that the rate will lift off before the end of this year, as the normalization of monetary
policy gets underway.
The approach of liftoff reflects the significant progress we have made toward our objectives
of maximum employment and price stability. The extraordinary monetary policy
accommodation that the Federal Reserve has undertaken in response to the crisis has
contributed importantly to the economic recovery, though the recovery has taken longer than
we expected. The unemployment rate, at 5.5 percent in February, is nearing estimates of its
natural rate, and we expect that inflation will gradually rise toward the Fed's target of
2 percent. Beginning the normalization of policy will be a significant step toward the
restoration of the economy's normal dynamics, allowing monetary policy to respond to
shocks without recourse to unconventional tools.
I would like to take this occasion to look back on some lessons learned during our time at the
effective lower bound on the interest rate, and also to look forward.1
Monetary policy since the crisis
Let me first take a step back in time. Prior to the crisis, the financial system was more fragile
than we realized. Key vulnerabilities included excessive leverage, overdependence on
shortterm funding, and deficiencies in credit ratings, underwriting standards, and risk
management. Importantly, interconnections across financial institutions heightened the risk of
contagion through cascading losses. Some of these interconnections emerged from the use
of complicated financial instruments that created seemingly safe and liquid assets. At the
time, it was common to say that risk was being dispersed and allocated to those best able to
bear it. But rather than distributing risk widely, these instruments concentrated risk on the
balance sheets of a relatively small number of highly levered financial institutions.
As a result, as the subprime crisis developed, market participants pulled back from risk
taking, leading to deleveraging spirals and fire sales.2 The damage spread across the globe.
Following the collapse of Lehman Brothers on September 15, international trade collapsed
as panic and financial connections transmitted distress across borders.3 Of course, the
economy's vulnerabilities did not stem from the private sector alone: in the public sector,
gaps in the regulatory structure allowed important financial institutions to escape
comprehensive supervision, and regulators were insufficiently focused on the stability of the
system as a whole.
The Federal Reserve responded aggressively to the crisis.4 By the end of 2008, the Federal
Open Market Committee (FOMC) had reduced the target federal funds rate from
5-1/4 percent to, effectively, zero. The Fed also acted forcefully as the lender of last resort -
in its traditional role of providing short-term liquidity to depository institutions, and also by
providing liquidity directly to borrowers and investors in key credit markets.5
In addition, the worldwide scope of the crisis called for concerted international action.
Because of the global nature of dollar funding markets, the Fed authorized dollar liquidity
swap lines with major central banks, beginning in December 2007. In October 2008, central
bankers coordinated reductions in policy rates and the Group of Seven agreed to use all
available tools to prevent the failure of systemically important financial institutions.6 The next
month, the Group of Twenty announced a broad common strategy, including fiscal
expansion.
These steps likely prevented a second Great Depression, but they were not sufficient to
avoid a severe global contraction.
In the United States, with the federal funds rate at its effective lower bound by the end of
2008, the FOMC judged that it could not provide much additional accommodation via its
conventional tool - reducing the federal funds rate.7 Instead, the FOMC used two
unconventional tools: large-scale asset purchases and enhanced forward guidance. To
varying extents, foreign central banks have also been using these tools.
The Fed's asset purchases did not have the conventional aim of increasing reserve balances
to pull down short-term rates.8 Rather, purchases of longer-term securities lowered
longerterm yields through portfolio balance effects.
The evolution of our asset purchases reflected a learning process for policymakers. In the
early programs, the FOMC specified the expected quantities of assets to be acquired over a
defined period. In contrast, with QE3 (the most recent round of quantitative easing,
implemented from September 2012 to October 2014), the FOMC announced that we would
continue to purchase securities at a certain monthly pace until the outlook for the labor
market improved substantially in a context of price stability. Later, the FOMC noted that the
pace of purchases was also data dependent, allowing the pace to be revised based on its
assessment of progress toward its long-run objectives.
4
A key trigger for the crisis was the decline in housing prices, which began in 2006 and led to uncertainty about
mortgage investments. In the summer of 2007, two large financial institutions - The Bear Stearns Companies,
Inc., and BNP Paribas Group - suspended redemptions from certain investment funds, perhaps marking the
beginning of the financial crisis. In 2008, the crisis intensified with the near collapse of Bear Stearns in March
and the bankruptcy of Lehman Brothers Holdings in September; a full-scale financial panic ensued across
much of the global financial system.
5
In our role as lender of last resort, we worked closely with the Treasury Department and the Federal Deposit
Insurance Corporation (FDIC). For example, to stem the run on money market funds, the Treasury provided a
temporary guarantee and the Fed created a backstop liquidity program. In addition, the FDIC established the
Temporary Liquidity Guarantee Program to guarantee certain unsecured liabilities of depository institutions
and some bank holding companies.
6
On October 8, 2008, the Federal Reserve and five other major central banks jointly announced a reduction in
policy interest rates. See Bank of Canada and others (2008).
7
A handful of central banks in Europe have recently set certain policy rates below zero. Specifically, the
Danmarks Nationalbank, the European Central Bank, the Sveriges Riksbank, and the Swiss National Bank
have set negative policy rates. In the United States, when the Federal Reserve sought to provide more
accommodation despite the federal funds rate being, essentially, zero, we chose not to use negative rates,
judging at the time that the small additional support for aggregate demand was not worth the accompanying
risks to U.S. money markets and the intermediation of credit.
8
Indeed, the maturity extension program - also known as Operation Twist - did not increase reserves at all.
With the federal funds rate near zero and the Fed creating and adjusting new asset purchase
programs, it became difficult for the public to anticipate how the FOMC would likely conduct
monetary policy and respond to changing economic conditions. Thus, the FOMC began to
rely heavily on enhanced forward guidance to communicate its intentions. Forward guidance
works in part because it also constrains the flexibility of decisionmakers when the time
comes to make their future decisions.9
Nonetheless, a number of potential costs might be associated with unconventional tools.
When interest rates are extremely low, risks to financial stability might grow. In addition,
elevated securities holdings could reduce the Fed's income and remittances to the U.S.
Treasury when rates eventually rise.10
Further, the Fed's quantitative easing appeared significantly to affect foreign asset markets,
and to have contributed to a surge of capital inflows to emerging-market economies
(EMEs).11 Our asset purchase programs were even called a "currency war." However,
eventually, most EMEs seemed glad to receive those flows. Interestingly, the asset
purchases recently announced by the European Central Bank (ECB) appear to be putting
downward pressure on longer-term interest rates in the United States. In addition, the ECB's
policy should increase growth in Europe, which will be beneficial for U.S. exports. Although
some of these benefits may be offset by the recent appreciation of the dollar, much of that
increase likely reflects other factors including the relatively strong performance of the U.S.
economy.
Looking back, there is ample evidence that supports the view that the Fed's asset purchases
contributed to a stronger U.S. recovery, by raising the prices of the assets purchased and
close substitutes, as well as those of riskier assets.12 Our experience also shows that forward
guidance helped better align market expectations of Fed policy with the Committee's policy
intentions.13 In brief, unconventional policies helped bring down long-term yields both by
reducing term premia and by lowering the expected path of future short-term rates.
9
There is a long literature in monetary economics about time inconsistency. Time inconsistency is the notion
that, to achieve good outcomes, a central bank may need to make commitments about how it will act in the
future - commitments that must be credible but that, ex post, the central bank might find hard to follow through
on. For canonical papers, see Kydland and Prescott (1977) and Lucas and Stokey (1983); see also Fischer
(1980). The early literature focused on the inability of central banks, in normal times, to commit to high future
interest rates and low inflation. Interestingly, at the zero lower bound, central banks may face nearly the
opposite commitment problem: To escape a liquidity trap, a central bank may want to commit to keep interest
rates low and accommodate an output boom even after the headwinds from a crisis have dissipated. See, for
example, Eggertsson (2006) and Werning (2012). For additional discussion of Federal Reserve
communications, see Yellen (2012) and Stein (2014).
10
For a discussion of the Federal Reserve's remittances, see Yellen (2013). Though it is likely that remittances
to the Treasury will decline later in the decade as interest rates increase, such developments would not impair
the Federal Reserve's conduct of monetary policy, and it is highly likely that average annual remittances over
the period affected by our asset purchases will be higher than pre-crisis norms. In addition, the asset
purchases also affect Treasury revenue by lifting economic activity and thereby tax revenue, as well as by
lowering interest rates and thereby debt service costs.
11
Regarding the effects on foreign asset markets, see Neely (2011); Fratzscher, Lo Duca, and Straub (2013);
and Rogers, Scotti, and Wright (2014). Regarding the effects on EMEs, it appears that both conventional and
unconventional policies in the United States - among other factors - have driven capital flows into EMEs. See,
for example, Ahmed and Zlate (2014) and Bowman, Londono, and Sapriza (2014).
12
See, for example, D'Amico and King (2013); Gagnon and others (2011); Gilchrist, López-Salido, and
Zakrajšek (2014); and Hamilton and Wu (2012).
13
See, for example, Yellen (2011).
The recovery from the financial crisis
Despite monetary stimulus, the recovery from the financial crisis has been even more
sluggish than we had expected. The slow recovery provides more evidence that severe
financial crises have long-lived effects, as Reinhart and Rogoff, and others, have
documented.14
The gradual pace of the recovery has likely reflected both demand and supply factors. With
respect to aggregate demand, the economy faced several important headwinds: efforts by
households and businesses to rebuild their balance sheets, persistently tight credit
conditions, the extreme weakness of the housing sector, the significant drag from fiscal
policy in the years from 2011 to 2013, and the growth slowdown in Europe and other parts of
the world.
Turning to aggregate supply, it appears that productivity growth has slowed.15 One notable
manifestation of slow productivity growth is that last year, unemployment fell significantly
further than we had anticipated as of the start of the year - a pattern that occurred in the
prior four years as well - whereas gross domestic product growth fell short of our
expectations, as it had in three of the four prior years. However, productivity is extremely
difficult to predict. For my part, I believe that the enormous gains in human welfare that the
information technology explosion seems to be generating are likely to continue, and will
perhaps eventually return measured productivity growth to its long-run historical pace.
Conditions for Liftoff
Although the recovery has been slow, there has been significant cumulative progress. An
increase in the target federal funds range likely will be warranted before the end of the year.
Liftoff should occur when the expected return from raising the interest rate outweighs the
expected costs of doing so. In deciding when that time has come, we will continue to monitor
a wide range of information regarding labor market conditions, inflation, and financial and
international developments. We anticipate that it will be appropriate to raise the target range
when there has been further improvement in the labor market and we are reasonably
confident that inflation will move back to our 2 percent objective over the medium term.
Policy normalization
Full normalization of monetary policy would allow the Fed to rely on its traditional policy
framework of adjustments to the federal funds rate. However, as long as our balance sheet
remains sizable, we will not be able to implement monetary policy with our traditional tool of
repurchases. It is important that, when we change the rate for the first time in a long time, we
are certain that we have the operational tools to control the federal funds rate - and,
accordingly, we have developed and tested new operational tools to control the federal funds
rate.
As discussed in the FOMC's statement titled Policy Normalization Principles and Plans,
which was published following the September 2014 FOMC meeting, we will use the rate of
interest on excess reserves (IOER) as our primary tool to control the federal funds rate.16 We
also plan to use an overnight reverse repurchase agreement (ON RRP) facility, as needed.
In an ON RRP operation, counterparties may invest funds with the Fed at a given rate,
possibly subject to a cap on the aggregate amount invested. Because ON RRP
counterparties include many money market participants that are not eligible to receive IOER,
the facility can be a powerful tool for controlling money market interest rates. Indeed, testing
to date by the New York Fed suggests that ON RRP operations have generally established a
soft floor for such rates.17
However, an ON RRP program also has certain risks. For example, a large and persistent
program could have unanticipated and adverse effects on the structure of money markets. In
addition, in times of stress, demand for the safety and liquidity of ON RRPs with the central
bank might increase sharply, potentially exacerbating disruptive flight-to-quality flows.18 To
mitigate these risks, the FOMC has agreed that it will use an ON RRP facility only to the
extent necessary and will phase it out when it is no longer needed.
In addition, the Fed has been discussing and testing other supplementary tools, such as term
reverse repurchase agreements and term deposits, and can use these tools as needed to
help support money market rates.
With regard to balance sheet normalization, the FOMC has indicated that it does not
anticipate selling agency mortgage-backed securities. When the time comes, we plan to
normalize the balance sheet primarily by ceasing reinvestment of principal payments on
existing holdings. When the FOMC chooses to cease reinvestments, the balance sheet will
naturally contract, with a corresponding reduction in reserve balances. This runoff of our
securities holdings will also gradually remove accommodation, an effect that we will need to
take into account in setting the stance of policy.
During normalization, we will, no doubt, learn more about our different tools and make
adjustments to our operating framework. In part because of this adaptability, I am confident
that by using IOER and, as needed, these supplementary tools, we will be able to raise
short-term interest rates when it becomes appropriate.
Monetary policy after liftoff
The focus of the great bulk of the discussion on monetary policy during the last few years,
has been on liftoff - on the circumstances under which the FOMC will choose to raise the
federal funds rate, on the date on which that will happen, and on the effect of the Fed's very
large portfolio on how it will manage the liftoff process. Those questions are natural after
more than six years during which the federal funds rate has been held at its effective lower
bound.
But as liftoff approaches, we need to think also about what will happen next. For liftoff is only
the start of the process of normalization, and, going forward, the FOMC will once again be
changing the federal funds rate as necessary, both up and down. Accordingly, discussion of
monetary policy needs to begin to shift to the future path of interest rates, and thus to the
basis on which the FOMC will set interest rates following liftoff.
There has been a lively discussion of one element of the future path of the federal funds rate:
whether liftoff should be sooner with a gradual rise in the rate, or whether liftoff should occur
later and be followed by a steeper path of the rate.19 These discussions are useful when
considering the appropriate timing of the first increase in the federal funds rate. But what
comes after the first increase? Standard interest rate projections might incline one to believe
that the path of the federal funds rate after liftoff will consist of a steady rate of increase from
zero to the longer-run normal nominal federal funds rate, which will be equal to the natural
real rate of interest plus our 2 percent inflation goal. One might even look back to the period
from 2004 to 2007 and conclude that the FOMC will raise the federal funds rate by 25 basis
points every meeting, or every second meeting, or every third meeting, depending on the
date of liftoff.
I know of no plans for the FOMC to behave that way. Why not? Isn't that what the calculation
of optimal control paths shows? Yes. But a smooth path upward in the federal funds rate will
almost certainly not be realized, because, inevitably, the economy will encounter shocks -
shocks like the unexpected decline in the price of oil, or geopolitical developments that may
have major budgetary and confidence implications, or a burst of greater productivity growth,
as the Fed dealt with in the mid-1990s.
When shocks happen, as they do, policymakers will have to respond to at least some of
them. Accordingly there is considerable uncertainty about the level of future interest rates - a
degree of uncertainty that can be estimated statistically, and that should be taken into
account by market participants and recognized by the FOMC when it discusses future levels
of interest rates. The uncertainty about future levels of the federal funds rate can be
represented in a "fan chart" - that is, a figure showing the expected path of the federal funds
rate as well as a range representing the degree of uncertainty around that path.20
The two sure elements of forward guidance that the FOMC will be able to offer after liftoff are
that monetary policy will continue to be aimed at fostering the Committee's dual objectives,
and that it will be data driven. As we move away from the zero lower bound, the data to
which we will be responding will be driven less and less by the financial crisis and Great
Recession, and increasingly by post-liftoff economic developments. Whatever the state of the
economy, the federal funds rate will be set at each FOMC meeting on the basis of what the
members of the FOMC believe will best enable us to meet our dual goals of maximum
employment and price stability over the course of time.
As the FOMC responds to incoming information, it will continue to be absolutely transparent
in explaining its decisions and how and why they contribute to meeting the legally mandated
dual goals of monetary policy. That transparency serves three purposes: First, it is required if
we are to be accountable to the public; second, it is the best way of ensuring that monetary
policy decisionmakers continue to follow sensible and rational policies; and third, it is the best
way of informing the private sector of the basis on which monetary policy decisions are made
and will continue to be made.
With respect to forward guidance: its role has been and continues to be important in the long
period in which eventual liftoff has been the key interest rate decision confronting the FOMC
and the focus of market expectations. However, as monetary policy is normalized, interest
rates will sometimes have to be increased, and sometimes decreased. Market participants
will be able to form their expectations of future interest rates on the basis of three elements:
first, the policy record of the FOMC, which might be approximated as a reaction function;
second, their analysis of the current economic and financial situation and outlook; and, third,
whatever guidance the FOMC will provide as to how it sees monetary policy decisions likely
to unfold given the economic situation and outlook. It is likely that explicit long-term forward
guidance will play less of a role in monetary policy after liftoff than it has during the past few
years.
Policymakers' behavior is sometimes summarized as a reaction function, which can be an
algebraic description of how the interest rate is set - for instance, a Taylor-type rule in which
the federal funds rate reacts simultaneously to the rate of inflation and expectations of
inflation as well as to the rate of unemployment and expected changes in the level of
unemployment.21 However, a simple rule of that sort will, by necessity, leave out many
factors that appropriately influence monetary policy, such as financial developments,
temporary divergences in relationships between different measures of economic activity or
inflation, and the like. A simple rule can provide the starting point for the decisions made by
the FOMC, but in reaching their interest rate decision, members of the Committee will always
have to use their judgment to identify the special circumstances confronting the economy,
and how to react to them.
To ensure that monetary policy operates in as stabilizing a way as possible, the FOMC will
continue to set out, as clearly as it can, the basis of every decision that it makes, and to
provide guidance on its expectations of future decisions. And on the basis of the information
provided by the FOMC, of their understanding of the historical record of Fed policy decisions,
and of their analysis and expectations of the state of the economy and, particularly, the
financial markets, market participants will make the best decisions they can.
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