Janet L Yellen: The Federal Reserve's asset purchase program
Speech by Ms Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the Brimmer Policy Forum, Allied Social Science Associations Annual Meeting,
Denver, Colorado, 8 January 2011.
* * *
I am delighted to participate in this Brimmer Policy Forum, not least because this year marks
the 45th anniversary of Andrew's appointment by President Johnson as a Governor of the
Federal Reserve Board. Andrew's ongoing work in organizing this annual forum reflects his
long-standing commitment to fostering economic analysis and public discourse on key policy
issues.
In my remarks today, I will discuss the rationale for the decision by the Federal Open Market
Committee (FOMC) in November to initiate a new program of asset purchases, and I will
address some frequently asked questions (FAQs) regarding the program's economic and
financial effects both here and abroad.1 The purpose of the new asset purchase program,
like all of the monetary policy actions taken by the FOMC since the onset of the global
financial crisis, is to fulfill our congressionally mandated objectives of promoting maximum
employment and price stability. In pursuit of these goals, the FOMC brought the target
federal funds rate down close to zero by late 2008; conducted large-scale purchases of
longer-term securities during 2009 and early 2010; and, last summer, modified its
reinvestment policy to keep the Federal Reserve's balance sheet from shrinking as
mortgage-related securities matured or were redeemed. In early November, the Committee
announced that it intends to purchase an additional $600 billion in longer-term Treasury
securities by the middle of this year.
The rationale for the asset purchase program
Macroeconomic conditions
To understand the rationale for our asset purchase program, it is helpful to review the
evolution of macroeconomic conditions over the past several years. The National Bureau of
Economic Research has dated the recession as having begun in December 2007, but the
pace of economic contraction accelerated in the wake of the Lehman Brothers collapse in
September 2008 and the ensuing disruption to global financial markets. As shown in figure 1,
the unemployment rate rose from around 5 percent in the spring of 2008 to about 10 percent
by the autumn of 2009 and has stayed well above 9 percent since then. Most observers,
including myself, judge this level of unemployment to be much higher than levels consistent
with full employment and stable inflation. For example, in a recent Survey of Professional
Forecasters conducted by the Federal Reserve Bank of Philadelphia, the median estimate of
the current level of structural unemployment - often referred to as the non-accelerating
inflation rate of unemployment (NAIRU) - stood at about 5-3/4 percent, implying that the
unemployment gap is nearly 4 percentage points.
In addition, a historically large fraction of the unemployed have been out of a job for a very
long time. For example, roughly 4 percentage points of today's unemployment rate reflects
individuals who have been unemployed for half a year or more. Those who experience an
extended period of unemployment face a risk of losing their ability to participate successfully
in the workforce, lending additional urgency to the task of reviving the demand for labor.
Such low rates of resource utilization are typically accompanied by falling inflation. And,
indeed, as shown in figure 2, measures of inflation for personal consumption expenditures
(PCE) have declined significantly since 2008. For the total PCE inflation rate, the underlying
trend is obscured to some extent by large swings in energy prices. However, the downward
trend is clearly evident from the evolution of core PCE inflation, which excludes the volatile
prices of food and energy. The 12-month change in core PCE prices dropped from about
2-1/2 percent in mid-2008 to around 1-1/2 percent in 2009 and declined further to less than
1 percent by late 2010.2
As inflation has trended downward, measures of underlying inflation have fallen somewhat
below the levels of about 2 percent or a bit less that most Committee participants judge to be
consistent, over the longer run, with the FOMC's dual mandate. In particular, a modest
positive rate of inflation over time allows for a slightly higher average level of nominal interest
rates, thereby creating more scope for the FOMC to respond to adverse shocks. A modest
positive inflation rate also reduces the risk that such shocks could result in deflation, which
can be associated with poor macroeconomic performance.
Of course, if incoming information last autumn had been pointing to greater momentum in the
prospects for economic growth or to a rapid escalation in inflation, then the case for further
monetary policy easing might have seemed less pressing. However, such was not the case.
The Federal Reserve publishes a Summary of Economic Projections (SEP) four times a year
in conjunction with the FOMC minutes. As shown in the November SEP, most Committee
participants anticipated that the economy would recover only gradually and projected that the
unemployment rate would still be at around 8 percent at the end of 2012 - an outlook that is
shared by most outside forecasters. Similarly, Committee participants generally expected
inflation to rise very gradually toward levels consistent with the Federal Reserve's mandate.
Moreover, continuing downside risks to the outlook for economic activity and inflation
strengthened the case for providing additional monetary policy accommodation, thereby
reducing the risk of another downturn in economic activity or a further decline in inflation.
The design of the asset purchase program
In weighing its policy options last autumn, the Committee gave careful consideration to the
question of whether further purchases of longer-term Treasury securities were likely to be
effective in fostering economic recovery and bringing inflation back up to levels judged to be
consistent with the dual mandate.3 In my judgment, both theoretical analysis and empirical
evidence suggested that such purchases could provide effective stimulus by keeping
longerterm interest rates lower than they would otherwise be.
2
This downward trend in inflation has not been confined to any specific sectors of the economy, such as
housing. For example, the Federal Reserve Bank of Dallas constructs a trimmed-mean rate of PCE inflation
by removing the tails of the distribution of monthly price changes for disaggregated spending categories. That
measure of underlying inflation has also declined fairly steadily since mid-2008 and dipped slightly below
1 percent last autumn. Moreover, diffusion indexes of price changes - which subtract the percentage of items
in the consumption basket with price increases from the percentage of items with price decreases - also fell
noticeably over this period, providing further evidence that the decline in inflation has been widespread across
many categories of consumer spending.
3
As indicated in the minutes of the November FOMC meeting, the Committee has also considered the potential
costs and benefits of setting a peg for a term interest rate. While targeting the yield on a term security could be
an effective way to reduce longer-term interest rates, such an approach might require the Federal Reserve to
make an open-ended commitment to purchasing longer-term securities.
The underlying theory, in which asset prices are directly linked to the outstanding quantity of
assets, dates back to the early 1950s.4 For example, in preferred-habitat models, short- and
long-term assets are imperfect substitutes in investors' portfolios, and the effect of
arbitrageurs is limited by their risk aversion or by market frictions such as capital constraints.
Consequently, the term structure of interest rates can be influenced by exogenous shocks in
supply and demand at specific maturities. Purchases of longer-term securities by the central
bank can be viewed as a shift in supply that tends to push up the prices and drive down the
yields on those securities.
In the context of such an analytical framework, the effect of an asset purchase program also
depends on investors' perceptions of the future path of short-term interest rates as well as
their perceptions of the timing and pace of the central bank's eventual unwinding of its asset
purchases. Thus, central bank communication may play a key role in influencing the financial
market response to such a program.
Recent empirical work provides a rough gauge of the quantitative effects of longer-term
securities purchases.5 For example, event studies have investigated the short-term response
of asset prices to announcements by the Federal Reserve and the Bank of England
regarding their respective asset purchase programs. And regression analysis has been used
to estimate statistical models that embed predictions from a specific theoretical framework.
Table 1 summarizes the response of selected financial variables on four dates associated
with the Federal Reserve's first round of asset purchases. On November 25, 2008, the
Federal Reserve announced that it would purchase up to $600 billion in agency
mortgagebacked securities (MBS) and agency debt. On December 1, Chairman Bernanke provided
further details in a speech.6 On December 16, the program was formally launched by the
FOMC.7 On March 18, 2009, the FOMC announced that the program would be expanded by
an additional $850 billion in purchases of agency MBS and agency debt and $300 billion in
purchases of Treasury securities. As is evident from the table, these announcements were
generally associated with a substantial decline in the 10-year Treasury yield and the yield on
10-year Treasury inflation-protected securities (TIPS) as well as in rates on agency MBS and
corporate debt.
Turning now to the macroeconomic effects of the Federal Reserve's securities purchases,
there are several distinct channels through which these purchases tend to influence
aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in
asset prices that boosts household wealth and spending, and a moderate change in the
foreign exchange value of the dollar that provides support to net exports. The quantitative
magnitude of these effects can be gauged using a macroeconometric model such as
FRB/US - one of the models developed and maintained by Board staff and used routinely in
simulations of alternative economic scenarios.
Figure 3 depicts the results of such a simulation exercise, as reported in a recent research
paper by four Federal Reserve System economists.8 For illustrative purposes, the simulation
4
Examples include Culbertson (1957), Tobin (1958), and Modigliani and Sutch (1966); see also Vayanos and
Vila (2009).
5
A burgeoning literature focuses on the experience of asset purchase programs of the Federal Reserve and
other central banks; for example, see D'Amico and King (2010); Gagnon, Raskin, Remache, and Sack (2010);
Hamilton and Wu (2010); and Joyce, Lasaosa, Stevens, and Tong (2010).
6
See Ben S. Bernanke (2008), "Monetary Policy and Asset Prices Revisited," speech delivered at the Greater
Austin Chamber of Commerce, Austin, Tex., December 1.
7
The December 2008 FOMC announcement also reported the Committee's decision to reduce the target for
the federal funds rate to a range of 0 to 1/4 percent.
8
See Chung and others (2011).
imposes the assumption that the purchases of $600 billion in longer-term Treasury securities
are completed within about a year, that the elevated level of securities holdings is then
maintained for about two years, and that the asset position is then unwound linearly over the
following five years.9
This trajectory of securities holdings causes the 10-year Treasury yield to decline initially
about 1/4 percentage point and then gradually return toward baseline over subsequent
years. That path of longer-term Treasury yields leads to a significant pickup in real gross
domestic product (GDP) growth relative to baseline and generates an increase in nonfarm
payroll employment that amounts to roughly 700,000 jobs.10 It should also be noted that this
exercise is performed as a deterministic simulation and hence does not capture the potential
benefits of the asset purchase program in mitigating downside risks to economic activity and
inflation.
I would also like to note that the same research paper analyzed the macroeconomic effects
of the FOMC's full program of securities purchases, including the first round of purchases
that was initiated in late 2008 and early 2009, the modification of the reinvestment policy that
was announced last August, and the second round of purchases that was initiated in
November. Those simulation results indicate that by 2012, the full program of securities
purchases will have raised private payroll employment by about 3 million jobs. Moreover, the
simulations suggest that inflation is currently a percentage point higher than would have
been the case if the FOMC had never initiated a securities purchases, implying that, in the
absence of such purchases, the economy would now be close to deflation.11
Addressing some FAQs about the asset purchase program
Has the program been effective in promoting the economic recovery?
Is the program actually proving effective? My short answer is yes. Table 2 depicts financial
market responses during three key phases in the rollout of the program: (1) August 10, 2010,
when the FOMC announced that the Federal Reserve would begin reinvesting principal
payments on agency MBS and agency debt by purchasing Treasury securities; (2) the period
between August 11 and November 2; and (3) November 3, the date on which the FOMC
meeting statement announced the commencement of the program.
As shown in the table, the initiation of the securities purchase program at the November
FOMC meeting occasioned only minimal market response. The reason is that it was largely
anticipated by investors, having been the subject of extensive public discussions by Federal
Reserve officials during late summer and early autumn. Importantly, as expectations of the
program gradually became embedded in asset prices during late summer and early autumn,
the 10-year TIPS yield dropped nearly 1/2 percentage point over the period between the
August and November FOMC meetings; moreover, equity prices rose and corporate bond
spreads narrowed. Over that period, of course, asset prices were also responding to
economic news and some favorable corporate earnings reports, but the overall pattern of the
financial market data bolstered my confidence in the effectiveness of the Federal Reserve's
securities purchases in providing additional monetary policy accommodation. Indeed, market
rates might well have backed up significantly following the November FOMC meeting if the
Committee had decided not to move ahead with the program.12
As shown in figure 4, longer-term Treasury yields have risen substantially over the past
couple of months since the FOMC initiated this round of asset purchases. I believe that this
increase in Treasury yields likely reflects a number of significant factors, including incoming
information suggesting a somewhat stronger economic outlook and the fiscal package that
was announced by President Obama in early December and approved by the Congress
about two weeks later; that package will not only support economic growth next year but will
also increase the amount of federal debt issuance. Also, investors appear to have scaled
back their expectations about the extent to which the FOMC will engage in further purchases
beyond those already announced; however, the effect of that reassessment on market rates
tends to bolster the view that the Federal Reserve's securities purchases do indeed affect
yields in the direction indicated by analytical and empirical studies.13
Will the asset purchase program lead to excessive inflation?
A concern voiced by some observers is that the asset purchase program will lead to
excessive inflation. One rationale for this view is that the economy is currently operating with
little slack - that is, an unemployment rate that is not far from the NAIRU. A second rationale
is that asset purchases have ballooned the Fed's balance sheet and the supply of bank
reserves. I will consider each argument in turn.
Extent of slack in the economy. Some proponents of the view that the U.S. economy is
operating close to the NAIRU point to an apparent outward shift in the Beveridge curve - the
relationship between job vacancies and unemployment - as indicating an increase in the
structural level of unemployment. In the simplest framework, movements along a downward
sloping Beveridge curve are typically characterized as cyclical movements in labor market
conditions, while persistent inward and outward shifts in the curve are frequently attributed to
structural forces.
As shown in figure 5, the Beveridge curve appears to have shifted out in recent years.
However, the Beveridge curve can shift out for a variety of reasons, including some that are
essentially cyclical in nature, so it is important to understand the sources of a shift to assess
whether it represents persistent structural forces.
There is some evidence suggesting that structural factors account for a portion of the
Beveridge curve's outward shift. In particular, the shift may partly reflect a decline in the
efficiency with which unemployed workers are matched to vacant jobs.14 However, given that
the apparent decline in matching efficiency coincided with a large reduction in job vacancies,
the two developments may be related. In particular, weak labor demand may be causing the
labor market to operate less efficiently than would typically be the case, and matching
efficiency may return to normal as demand for workers improves. Indeed, historically,
matching efficiency does appear to move back toward its long-run average over time.15 That
said, a persistently high level of long-term unemployment could lead to a significant increase
in structural unemployment over time as individuals who are out of work for long periods face
the erosion of their skills. However, such effects would take time to materialize and, in any
event, would argue for aggressive policies to reduce unemployment promptly.
Another portion of the recent outward shift in the Beveridge curve is likely due to increases in
the maximum duration of unemployment benefits, which may have induced some
unemployed workers to be more selective in the job offers they accept. However, recent
research suggests that the increase in unemployment due to extended benefits is probably
small relative to the overall increase in unemployment, and, regardless of its magnitude, the
influence of extended unemployment benefits will disappear as the economy improves and
extended benefits expire.16
Moreover, at least some of the recent outward shift in the Beveridge curve appears to reflect
cyclical rather than structural influences. For example, vacancies typically adjust more
quickly than unemployment to changes in labor demand, causing counterclockwise
movements in vacancy-unemployment space that can look like shifts in the Beveridge curve.
Indeed, as is evident from the figure, such counterclockwise movements have occurred in
most previous recessions.
Finally, it is worth emphasizing that most of the co-movement between unemployment and
vacancies in recent years does not appear especially unusual. In particular, low vacancies
and elevated layoffs - likely driven by weak labor demand - can account for much of the
increase in unemployment that has occurred since mid-2008.17 This observation is in accord
with the recent behavior of inflation, which, as noted above, has trended down over the past
three years, consistent with a decline in rates of resource utilization. Likewise, nominal wage
growth has fallen noticeably over the past several years and remains quite low.
In sum, while deficient labor demand may not be the only factor boosting unemployment
currently, and while disentangling the various influences on unemployment is not
straightforward, weak labor demand appears to be the predominant factor keeping the
unemployment rate elevated. This weakness, in turn, implies that current resource utilization
is likely well below normal levels, mitigating the risk that the policy stimulus from our asset
purchase program will lead to excessive inflation.
Inflation and bank reserves. A second reason that some observers worry that the Fed's
asset purchase programs could raise inflation is that these programs have increased the
quantity of bank reserves far above pre-crisis levels. I strongly agree with one aspect of this
argument - the notion that an accommodative monetary policy left in place too long can
cause inflation to rise to undesirable levels. This notion would be true regardless of the level
of bank reserves and pertains as well in situations in which monetary policy is unconstrained
by the zero bound on interest rates. Indeed, it is one reason why the Committee stated that it
will review its asset purchase program regularly in light of incoming information and adjust
the program as needed to meet its objectives. We recognize that the FOMC must withdraw
monetary stimulus once the recovery has taken hold and the economy is improving at a
healthy pace. Importantly, the Committee remains unwaveringly committed to price stability
and does not seek inflation above the level of 2 percent or a bit less than that, which most
FOMC participants see as consistent with the Federal Reserve's mandate.
In contrast, I disagree with the notion that the large quantity of reserves resulting from our
asset purchases poses some special barrier to removing policy stimulus when the right time
comes. The FOMC will be able to increase short-term rates by raising the interest rate that
we pay on excess reserves - currently 1/4 percent. That ability will allow us to manage
shortterm interest rates effectively and thus to tighten policy when needed, even if bank reserves
remain high.
Given the very high level of reserve balances, changes in the interest rate on reserves might
not be fully reflected in the federal funds rate and other short-term market rates. In that
event, the Federal Reserve can use tools it has developed and tested to drain or immobilize
bank reserves, thereby enhancing our control over the federal funds rate. To build the
capability to drain large quantities of reserves, the Federal Reserve has expanded the range
of its counterparties for reverse repurchase operations beyond the primary dealers and has
developed the infrastructure necessary to use agency MBS as collateral in such transactions.
The Federal Reserve has also put in place a Term Deposit Facility through which it can offer
deposits to member institutions that are roughly analogous to the certificates of deposit that
these institutions offer to their customers. We have tested both of these tools by conducting
several small-scale operations and have the ability to initiate them quickly if needed. The use
of reverse repurchase operations and the Term Deposit Facility would allow the Federal
Reserve to drain hundreds of billions of dollars of reserves from the banking system should
conditions necessitate. We don't think that draining such large amounts of reserves will be
necessary for a smooth exit, but it makes sense to be prepared, and hence we have followed
this "belt and suspenders" approach.
Finally, we can sell portions of our holdings of MBS, agency debt, and Treasury securities if
we determine that doing so is an appropriate way of tightening financial conditions when the
time comes. The redemption or sale of securities would have the effect of reducing the size
of the Federal Reserve's balance sheet as well as further reducing the quantity of reserves in
the banking system. Restoring the size and composition of the balance sheet to a more
normal configuration is a longer-term objective of our policies. Any such sales would be at a
gradual pace, would be clearly communicated to market participants, and would entail
appropriate consideration of economic conditions.
In short, the range of tools we have developed will permit us to raise short-term interest rates
and drain large volumes of reserves when it becomes necessary to achieve the policy stance
that fosters our macroeconomic objectives - including the objective of maintaining price
stability.
Will the asset purchase program result in adverse financial imbalances?
The Committee's intention in implementing asset purchases is to hold down the level of
longer-term interest rates to make credit more affordable for businesses and households. A
reasonable fear is that this process could go too far, encouraging potential borrowers to
employ excessive leverage to take advantage of low financing costs and leading investors to
accept less compensation for bearing risks as they seek to enhance their rates of return in an
environment of very low yields.
This concern deserves to be taken seriously, and the Federal Reserve is carefully monitoring
financial indicators for signs of potential threats to financial stability. While there is no single
metric we can use to assess these threats, standard financial market indicators do not
currently signal significant excesses or imbalances in the United States. In the stock market,
for example, price-to-earnings ratios, by some measures, remain below their averages over
the past several decades, and other valuation measures also indicate that equity prices are
not significantly out of alignment with past norms. In the real estate market, price-to-rent
ratios for both residential and commercial real estate are now within a reasonable range of
their long-run averages, in contrast to the severe misalignment that occurred prior to the
crisis. Again, there is little sign here of imbalances relative to fundamentals, at least if history
is used as a guide. In fixed-income markets, narrow risk spreads and risk premiums could be
signs of excessive risk-taking by investors, and indeed spreads on corporate bonds have
dropped dramatically since the financial crisis, as the economic outlook has improved and
investor sentiment has picked up. Risk premiums on nonfinancial corporate bonds, as
measured by forward spreads far in the future, are relatively low compared with historical
norms, although other indicators for this market do not point to overvaluation.
An alternative way to identify imbalances is to focus more directly on measuring credit flows
and exposures to credit risk. Extraordinarily rapid credit growth may be a sign that financial
institutions are taking greater risks onto their balance sheets. In recent months, nonfinancial
corporations have issued large amounts of bonds and syndicated leveraged loans, and
banks' provision of consumer credit has shown some signs of reviving. Nonetheless, a
portion of the recent corporate issuance has been used to refinance existing debt, including
leveraged loans; small business lending remains especially weak; and commercial and
residential mortgage originations continue to shrink. Thus, there is little evidence that
financial institutions are significantly expanding the level of credit and liquidity provided to
households and businesses on net. Indeed, given the current very low level of interest rates
and the continuation of the economic recovery, credit flows remain stubbornly sluggish.
Of course, such aggregate measures provide only an imperfect picture of overall credit
conditions. Another type of evidence comes from surveying market participants about their
practices. For bank lending, we have the Federal Reserve's Senior Loan Officer Opinion
Survey on Bank Lending Practices, which provides information about changes in supply and
demand for bank loans to businesses and households. Recent surveys have indicated that
banks have only just begun to reverse the historically large tightening in standards and terms
that they implemented in the aftermath of the crisis. In fact, considerably more easing of
terms and standards will probably be required before lending conditions return to normal.
To monitor leverage provided by dealers to financial market participants, last June the
Federal Reserve launched the Senior Credit Officer Opinion Survey on Dealer Financing
Terms. This survey provides information on credit terms and availability of various forms of
dealer-intermediated financing, including funding for securities positions and
over-thecounter derivatives. The survey results suggest that over the past several months there has
been some easing of terms applicable to financing for a range of counterparty types and
many types of collateral, as well as an increase in demand from clients to fund most types of
securities. These results indicate that the availability and use of leverage by nonbank
financial institutions increased somewhat last year. Overall, a variety of indicators suggest
that leverage generally remains well below the levels reached prior to the financial crisis, but
these measures are worth watching closely, and the new survey reflects our strong
commitment to developing additional tools for this purpose.
The Federal Reserve is closely monitoring many indicators of financial conditions to better
understand the implications of financial market developments for the economy as well as
risks to the financial system itself. We are working with other regulators to make the financial
system more robust and are attentive in our supervision to developments that may affect
systemic risk. If evidence of financial imbalances were to develop, I believe that supervision
and regulation should provide the first line of defense so that monetary policy can
concentrate on its longstanding goals of price stability and maximum employment. That said,
we cannot categorically rule out using monetary policy to address financial imbalances, given
the damage that they can cause.
Will the asset purchase program have adverse effects on foreign economies?
My final FAQ relates to the concerns that some observers have expressed over the potential
for the Federal Reserve's asset purchase program to have adverse effects on foreign
economies. One specific concern is that these securities purchases might drive down the
value of the U.S. dollar, thereby diverting demand from our trading partners. Although
purchases of longer-term securities are a less conventional means of conducting monetary
policy than the more familiar approach of managing short-term interest rates, the goals and
transmission mechanisms are actually very similar, and there is nothing special about these
asset purchases that would make them especially likely to weigh on the dollar.
In fact, the evidence available to date suggests that the asset purchases have had only
moderate effects on the foreign exchange value of the dollar. This point is illustrated in
table 3, which reports the change in U.S. dollar exchange rates against four other currencies
(the Canadian dollar, pound sterling, euro, and yen) on each of the four dates referred to in
table 1. These movements in exchange rates are not particularly large when compared with
the fluctuations that can occur in any given week or month. Indeed, as shown in figure 6,
these exchange rate movements are very modest in the broader context of developments
over the past several years.
A related concern raised by some observers is that the Federal Reserve's asset purchases
may induce excessive capital inflows to emerging market economies (EMEs) - inflows that in
turn could put unwelcome upward pressure on the currencies of those EMEs and perhaps
even contribute to asset price bubbles. As shown in figure 7, net private capital flows to Latin
American and Asian EMEs (reported as a share of the aggregate GDP of those EMEs) were
substantial in the second half of 2009 and the first half of 2010 but were not obviously
outsized compared with levels prior to the crisis.18 A similar pattern is evident in figure 8,
which depicts the net inflows since 2007 into mutual funds investing in EME bonds and
equities. In each case, the strong inflows over the past year or so reflect a recovery in the
wake of the large outflows that occurred during the crisis. In fact, the stock of claims on
EMEs has only returned to its pre-crisis trend.
Accommodative monetary policies in the advanced economies, including the Federal
Reserve's asset purchases, have likely played some role in widening interest rate
differentials and encouraging capital flows to EMEs. But this role shou