Stanley Fischer: Conducting monetary policy with a large balance sheet
Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve
System, at the 2015 US Monetary Policy Forum, sponsored by the University of Chicago
Booth School of Business, New York City, 27 February 2015.
* * *
Accompanying charts can be found at the end of the speech.
Thank you. It is a great pleasure to be here to discuss some of the important issues facing
the Federal Reserve and other central banks in conducting monetary policy with a large
balance sheet. I will focus on two main sets of issues that the Fed has faced and will
continue to face for some time. The first involves our ongoing assessment of the effects of
the asset purchases. The second concerns policy normalization in the presence of a very
large balance sheet.
To set the stage, consider the size of the Fed's balance sheet over the past several years.
Assets have risen from about $900 billion in 2006 to about $4.5 trillion today, or - as seen in
figure 1 - from 6 percent of nominal gross domestic product (GDP) to about 26 percent of
nominal GDP. The net expansion over this period reflects primarily our large-scale asset
purchase programs.
Of course, many other central banks have expanded their balance sheets substantially over
recent years as well. For example, assets of the Bank of Japan have increased from about
20 percent of nominal GDP to more than 60 percent of nominal GDP over this period, and
assets of the Swiss National Bank have increased from 20 percent of nominal GDP to more
than 80 percent of nominal GDP. The net increase in assets of the European Central Bank
has so far been more modest, with assets increasing from less than 10 percent of nominal
GDP to more than 20 percent of nominal GDP - but their quantitative easing (QE) program is
not yet under way.
For the remainder of my remarks, I will focus on the Fed, beginning with some remarks about
the asset purchase programs.
The Federal Reserve asset purchase programs
The nature of our purchase programs has changed over time. In the early programs - that is
to say, QE1, QE2, and the program we call the MEP, or the maturity extension program,
otherwise known as "Operation Twist" - the Federal Open Market Committee (FOMC)
specified the expected quantities of assets to be acquired over a defined period. Early in the
crisis, this strategy seemed to help bolster confidence that the Fed was acting aggressively
to offset the tightening in credit conditions and the steep downturn in economic activity.
The communication of asset purchases changed with QE3. In September 2012, the FOMC
launched an open-ended asset purchase program in which it directed the New York Fed's
Open Market Desk to conduct purchases at an announced monthly pace until there was
"significant improvement" in the outlook for the labor market. Later, the FOMC noted that the
monthly pace of purchases was data dependent, allowing the pace to be revised up or down
based on its assessment of progress toward its long-run objectives.
Both of these types of asset purchase programs were aimed at putting downward pressure
on long-term yields.1 Table 1 provides a summary of various studies' estimated effects of
these programs on the term premium on 10-year Treasury securities. For example, the
decline in 10-year Treasury yields associated with the first purchase program is estimated to
have been as large as 100 basis points. The documented effects associated with subsequent
programs are generally smaller. These results raise the question of whether the marginal
effect of asset purchases has declined over time. While that question is a valid one, our
conclusion is that asset purchases over more recent years have provided meaningful
stimulus to the economy, and continue to do so.
Figure 2 provides a current estimate, based on Fed staff calculations, of the effect on the
term premium on 10-year Treasury securities from the combination of all asset programs.2
The results suggest that the Fed's balance sheet programs are currently depressing 10-year
Treasury yields by about 110 basis points. And, with the Fed continuing to hold these
securities, they should apply downward pressure on rates for some time.
The declines in long-term yields have led to an associated drop in long-term borrowing costs
for households and firms and higher equity valuations. Thus, the asset purchases have
helped make financial conditions overall more accommodative and have provided significant
stimulus for the broader economy. As shown in figure 3, a recent study estimates that the
QE programs along with increasingly explicit forward guidance have reduced the
unemployment rate by 1-1/4 percentage points and increased the inflation rate by
1/2 percentage point relative to what would have occurred in the absence of these policies.3
Moreover, the estimates imply that these macroeconomic effects are only now manifesting
themselves in full, reflecting the inherent lags in the monetary transmission mechanism. Of
course, such estimates have a wide band of uncertainty around them.
As is well known, a number of potential costs might be associated with QE and the Fed's
elevated balance sheet. Among these are the possibility that elevated securities holdings and
low interest rates could pose risks to financial stability, possible effects on the Fed's income
and remittances to the U.S. Treasury, and possible difficulties in conducting policy
normalization.4 Such potential difficulties arise because the level of reserve balances will be
very high when the FOMC begins to raise the federal funds rate, and, consequently, the
Federal Reserve will employ new tools, which have their own benefits and costs, to
implement monetary policy.
Despite these potential costs, we think that asset purchases have had a meaningful effect in
promoting economic recovery and helping to keep inflation closer to the FOMC's 2 percent
goal than would otherwise have been the case.
Effects of Large-Scale Treasury Purchases: Evidence on the Importance of Local Supply," Journal of Financial
Economics, vol. 108 (May), pp. 425-48; and John Kandrac and Bernd Schlusche (2013), "Flow Effects of
Large-Scale Asset Purchases," Economics Letters, vol. 121 (November), pp. 330-35).
2
The estimates shown in figure 2 are based on an extension of the work done in Ihrig, Klee, Li, Schulte, and
Wei (2012). Because the term premium effect depends on both the Fed's current and expected future asset
holdings, most of this effect - without further unexpected policy actions - will likely wane over the next few
years as the balance sheet begins to normalize. See Jane Ihrig, Elizabeth Klee, Canlin Li, Brett Schulte, and
Min Wei (2012), "Expectations about the Federal Reserve's Balance Sheet and the Term Structure of Interest
Rates (PDF)," Finance and Economics Discussion Series 2012-57 (Washington: Board of Governors of the
Federal Reserve System, July).
3
See Eric Engen, Thomas Laubach, and David Reifschneider (2015), "The Macroeconomic Effects of the
Federal Reserve's Unconventional Monetary Policies (PDF)," Finance and Economics Discussion Series 2015
005 (Washington: Board of Governors of the Federal Reserve System, January).
4
Reflecting securities holdings from the asset purchases, the Federal Reserve has remitted about $500 billion
to the U.S. Treasury from 2008 to 2014 and is expected to have cumulative net income from 2008 to 2025 that
is far higher than would have been the case in the absence of these asset purchases.
Policy normalization
Turning to policy normalization, the FOMC and market participants anticipate that the federal
funds rate will be raised sometime this year. We have for some years been considering ways
to operate monetary policy with an elevated balance sheet.
Prior to the financial crisis, because reserve balances outstanding averaged only around
$25 billion, relatively minor variations in the total amount of reserves supplied by the Desk
could move the equilibrium federal funds rate up or down. With the nearly $3 trillion in excess
reserves today, the traditional mechanism of adjustments in the quantity of reserve balances
to achieve the desired level of the effective federal funds rate may well not be feasible or
sufficiently predictable.
As discussed in the FOMC's statement on its Policy Normalization Principles and Plans,
which was published following the September 2014 FOMC meeting, we will use the rate of
interest paid on excess reserves (IOER) as our primary tool to move the federal funds rate
into the target range.5 This action should encourage banks not to lend to any private
counterparty at a rate lower than the rate they can earn on balances maintained at the Fed,
which should put upward pressure on a range of short-term interest rates.
Because not all institutions have access to the IOER rate, we will also use an overnight
reverse repurchase agreement (ON RRP) facility, as needed. In an ON RRP operation,
eligible counterparties may invest funds with the Fed overnight at a given rate. The ON RRP
counterparties include 106 money market funds, 22 broker-dealers, 24 depository
institutions, and 12 government-sponsored enterprises, including several Federal Home
Loan Banks, Fannie Mae, Freddie Mac, and Farmer Mac. This facility should encourage
these institutions to be unwilling to lend to private counterparties in money markets at a rate
below that offered on overnight reverse repos by the Fed. Indeed, testing to date suggests
that ON RRP operations have generally been successful in establishing a soft floor for
money market interest rates.6
The Fed could also employ other tools, such as term deposits issued through the Term
Deposit Facility and term RRPs, to help drain reserves and put additional upward pressure
on short-term interest rates. We have been testing these tools and believe they would help
support money market rates, if needed.
Finally, with regard to balance sheet normalization, the FOMC has indicated that it does not
anticipate sales of agency mortgage-backed securities, and that it plans to normalize the size
of the balance sheet primarily by ceasing reinvestment of principal payments on its existing
securities holdings when the time comes. As illustrated in figure 4, cumulative repayments of
principal on our existing securities holdings from now through the end of 2025 are projected
to be about $3.2 trillion. As a result, when the FOMC chooses to cease reinvestments, the
size of the balance sheet will naturally decline, with a corresponding reduction in reserve
balances.
Conclusion
I will close by highlighting that the Fed's asset purchases have been a critical means by
which the FOMC has provided policy accommodation at the zero lower bound on nominal
interest rates. In other words, the Fed - and other central banks - can implement an
expansionary monetary policy even when the policy interest rate is at the zero lower bound.
The current high level of securities holdings will present some challenges for policy
normalization, but we are confident that we have the tools necessary to remove
accommodation at the appropriate time and at the appropriate pace.
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