For release on delivery
10:00 p.m. EST (7:00 p.m. PST)
March 8, 2019
Monetary Policy: Normalization and the Road Ahead
Remarks by
Jerome H. Powell
Chair
Board of Governors of the Federal Reserve System
at
2019 SIEPR Economic Summit
Stanford Institute of Economic Policy Research
Stanford, California
March 8, 2019
Thank you for the opportunity to speak here today at the Stanford Institute for
Economic Policy Research, a place dedicated to scholarship supporting policies to better
peoples' lives. As today is International Women's Day, I would like to preface my
remarks by commending the American Economic Association for highlighting the
diversity challenges of the economics profession and charting a way forward. Diversity
is also a priority at the Fed: I want the Fed to be known within the economics profession
as a great place for women, minorities, and others of diverse backgrounds to be
respected, listened to, and happy.
Just over 10 years ago, the Federal Open Market Committee (FOMC, or the
Committee) lowered the federal funds rate close to zero, which we refer to as the
effective lower bound, or ELB. Unable to lower rates further, the Committee turned to
two novel tools to promote the recovery. The first was forward guidance, which is
communication about the future path of interest rates. The second was large-scale
purchases of longer-term securities, which became known as quantitative easing, or QE.
There is a range of views, but most studies have found that these tools provided
significant support for the recovery. From the outset, the Committee viewed them as
extraordinary measures to be unwound, or "normalized," when conditions ultimately
warranted.
Today I will explore some important features of normalization and then turn to
what comes after. In some ways, we are returning to the pre-crisis normal. In other
ways, things will be different. The world has moved on in the last decade, and
attempting to re-create the past would be neither practical nor wise. As normalization
moves into its later stages, my colleagues and I also believe that this is an important
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moment to take stock of issues raised by the remarkable experiences of the past decade.
We are therefore conducting a review of the Fed's monetary policy strategy, tools, and
communications practices. I will conclude with some thoughts on the review.
Balance Sheet Normalization
Between December 2008 and October 2014, the Federal Reserve purchased
$3.7 trillion in longer-term Treasury and agency securities in order to support the
economy both by easing dislocations in market functioning and by driving down longer-
term interest rates. Consistent with the Committee's long-stated intention, in October
2017 we started the process of balance sheet normalization. We began gradually
reducing the reinvestment of payments received as assets matured or were prepaid,
allowing our holdings to shrink. The process of reducing the size of the portfolio is now
well along.
To frame the discussion of the final stages of normalization of the size of the
balance sheet, it is useful to consider what the phrase "normal balance sheet" meant in the
decades before the crisis. During that period, the main monetary policy decision for the
FOMC was choosing a target value for the federal funds rate. Subject to that choice, the
Fed allowed the demand for its liabilities to determine the size of the balance sheet. This
is a feature of "normal" that we are returning to: After normalization, the size of the
Fed's balance sheet will once again be driven by the demand for our liabilities.
To see what this means, consider figure 1, which shows the size of the Fed's
balance sheet through time, as measured by total liabilities. The values are stated as a
percentage of the dollar value of GDP, or gross domestic product.1 Liabilities began to
- 3 -
grow sharply at the end of 2008 and continued to increase until the end of 2014. Since
that time, liabilities relative to GDP have fallen appreciably. To understand these
changes, it is useful to focus on a snapshot of the balance sheet at three points in time:
before the crisis, when the balance sheet was at its largest, and a rough projection for the
end of this year (table 1).
In 2006, the dominant liability was currency held by the public, and the dominant
asset was Treasury securities. The Fed's asset purchase programs increased the balance
sheet from just below 6 percent to nearly 25 percent of GDP by the end of 2014.2
Balance sheets must balance, of course, and the Fed issued reserves as payment for the
assets purchased. This action pushed reserves to nearly 15 percent of GDP.
The Committee has long said that the size of the balance sheet will be considered
normalized when the balance sheet is once again at the smallest level consistent with
conducting monetary policy efficiently and effectively. Just how large that will be is
uncertain, because we do not yet have a clear sense of the normal level of demand for our
liabilities. Current estimates suggest, however, that something in the ballpark of the
2019:Q4 projected values may be the new normal. The normalized balance sheet may be
smaller or larger than that estimate and will grow gradually over time as demand for
currency rises with the economy. In all plausible cases, the balance sheet will be
considerably larger than before the crisis.
To understand the differences between the new and old normal, consider the final
column in the table, which shows the change, measured in percentage points of GDP,
between 2006:Q4 and the 2019:Q4 projection in the table. In this estimate, relative to
- 4 -
before the crisis, the balance sheet will have grown as a share of GDP by about
10.6 percentage points. Bank reserves account for the biggest part of the growth, or
about 5.6 percent of GDP. The crisis revealed that banks, especially the largest and most
complex, faced much more liquidity risk than had previously been thought. Because of
both new liquidity regulations and improved management, banks now hold much higher
levels of high-quality liquid assets than before the crisis. Many banks choose to hold
reserves as an important part of their strong liquidity positions.
The rest of the increase in liabilities is accounted for by three other categories.
First, public currency holdings will have grown by 2.4 percentage points as a share of
GDP. Second, the U.S. Treasury maintains an account at the Fed, which has been
running 1.4 percentage points higher as a share of GDP. And, third, other liabilities,
which are mainly associated with the mechanics of the national and international
financial system, will have grown by 1.1 percentage points.
As was the case before the crisis, the FOMC's chosen operating regime for
controlling short-term interest rates also plays a role in determining the appropriate
quantity of reserves. In January, the Committee stated its intention to continue in our
current regime in which our main policy rate, the federal funds rate or possibly some
successor, is held within its target range by the interest rates we set on reserves and on the
overnight reverse repo facility.3 In this system, active management of the supply of
reserves is not required. Thus, the supply of reserves must be "ample," in the sense of
being sufficient to satisfy reserve demands even in the face of volatility in factors
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affecting the reserve market.4 Put another way, the quantity of reserves will equal the
typical reserve demands of depositories plus a buffer to allow for reserve market
fluctuations.
While the precise level of reserves that will prove ample is uncertain, standard
projections, such as those in the table, suggest we could be near that level later this year.
As we feel our way cautiously to this goal, we will move transparently and predictably in
order to minimize needless market disruption and risks to our dual-mandate objectives.
The Committee is now well along in our discussions of a plan to conclude balance sheet
runoff later this year. Once balance sheet runoff ends, we may, if appropriate, hold the
size of the balance sheet constant for a time to allow reserves to very gradually decline to
the desired level as other liabilities, such as currency, increase. We expect to announce
further details of this plan reasonably soon.
There is no real precedent for the balance sheet normalization process, and we
have adapted our approach along the way. In these final phases, we will adjust the details
of our normalization plans if economic and financial conditions warrant. After decisions
regarding the size of the balance sheet have been made, we will turn to remaining issues,
such as the ultimate maturity composition of the portfolio. The Committee has long
stated that it intends to return to a portfolio consisting primarily of Treasury securities.
Forward Guidance and the Normalization of Policy Communication
The Committee has also been normalizing communication about our policy after a
decade of forward guidance. Since December 2008, the FOMC's postmeeting statement
had contained ever-evolving forms of guidance about keeping the federal funds rate at the
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ELB or about the gradual pace at which that rate would return to more normal levels. We
removed the last elements of this crisis-era guidance in January.5 The federal funds rate
is now within the broad range of estimates of the neutral rate--the interest rate that tends
neither to stimulate nor to restrain the economy. Committee participants generally agree
that this policy stance is appropriate to promote our dual mandate of maximum
employment and price stability. Future adjustments will depend on what incoming data
tell us about the baseline outlook and risks to that outlook.
Policy communication will not simply revert to the ways of the early 2000s,
however, for transparency advances have continued apace since then. The most
significant change from the standpoint of forward guidance is that, since January 2012,
the FOMC's quarterly Summary of Economic Projections (SEP) has included federal
funds rate projections reaching up to three years into the future--often referred to as the
"dot plot." Returning to a world of little or no explicit forward guidance in the FOMC's
postmeeting statement presents a challenge, for the dot plot has, on occasion, been a
source of confusion. Until now, forward guidance in the statement has been a main tool
for communicating committee intentions and minimizing that confusion.
For example, in early 2014, the Committee's intentions were at odds with a
common misreading of the dots, and Chair Yellen explained, "[O]ne should not look to
the dot plot, so to speak, as the primary way in which the Committee wants to or is
speaking about policy to the public at large. The FOMC statement is the device that the
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Committee as a policymaking group uses to express its opinions . . . about the likely path
of rates."6 If the Committee remains largely out of the business of explicit forward
guidance, we will need to find other ways to address the collateral confusion that
sometimes surrounds the dots.
As readers of the FOMC minutes will know, at our last meeting in January there
was an impromptu discussion among some participants of general concerns about the
dots. My own view is that, if properly understood, the dot plot can be a constructive
element of comprehensive policy communication. Let me follow my two predecessors as
Chair in attempting to advance that proper understanding.
Each participant's dots reflect that participant's view of the policy that would be
appropriate in the scenario that he or she sees as most likely. As someone who has filled
out an SEP projection 27 times over the last seven years, I can say that there are times
when I feel that something like the "most likely" scenario I write down is, indeed,
reasonably likely to happen. At other times, when uncertainty around the outlook is
unusually high, I dutifully write down what I see as the appropriate funds rate path in the
most likely scenario, but I do so aware that this projection may be easily misinterpreted,
for what is "most likely" may not be particularly likely. Very different scenarios may be
similarly likely. Further, at times downside risks may deserve significant weight in
policy deliberations. In short, as Chairman Bernanke explained, the SEP projections are
merely "inputs" to policy that do not convey "the risks, the uncertainties, all the things
that inform our collective judgment."7
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Effectively conveying our views about risks and their role in policy projections
can be challenging at times, and we are always looking for ways to improve our
communications. I have asked the communications subcommittee of the FOMC to
explore ways in which we can more effectively communicate about the role of the rate
projections. For now, let me leave you with a cautionary tale about focusing too much on
dots. Here is a picture composed of different colored dots (figure 2). The meaning of it
is not clear, although if you stare at it long enough you might see a pattern. But let's take
a step back (figure 3). As you can see, if you are too focused on a few dots, you may
miss the larger picture.
Delivering on the FOMC's intention to ultimately normalize policy continues to
be a major priority at the Fed. Normalization is far along, and, considering the
unprecedented nature of the exercise, it is proceeding smoothly. I am confident that we
can effectively manage the remaining stages.
Beyond Normalization
We live in a time of intense scrutiny and declining trust in public institutions
around the world. At the Fed, we are committed to working hard to build and sustain the
public's trust. The Fed has special responsibilities in this regard. Our monetary policy
independence allows us to serve the public without regard to short-term political
considerations, which, as history has shown, is critical for sound monetary policymaking.
But that precious grant of independence brings with it a special obligation to be open and
transparent, welcoming scrutiny by the public and their elected representatives in
Congress. Only in this way can the Fed maintain its legitimacy in our democratic system.
- 9 -
Among other initiatives, my colleagues and I on the FOMC are undertaking a
year-long review of the Federal Reserve's monetary policy strategy, tools, and
communication practices. The review will involve a series of "Fed Listens" events
around the country. These will include town-hall-style meetings and a conference where
academic and nonacademic experts will share their views. These events will inform staff
work and FOMC discussions as we plan for the future. While this is the first time the
Fed has opened itself up in this way, many central banks around the world have
conducted similar reviews, and our approach builds on their experiences.
We believe that our existing framework for conducting monetary policy has
generally served the public well, and the review may or may not produce major changes.
Consistent with the experience of other central banks with these reviews, the process is
more likely to produce evolution rather than revolution. We seek no changes in law and
we are not considering fundamental changes in the structure of the Fed, or in the 2
percent inflation objective. While there is a high bar for adopting fundamental change, it
simply seems like good institutional practice to engage broadly with the public as part of
a comprehensive approach to enhanced transparency and accountability.
Without ruling out other topics, we have highlighted three questions that seem
particularly important at present (figure 4):
1. Can the Federal Reserve best meet its statutory objectives with its
existing monetary policy strategy, or should it consider strategies that aim to
reverse past misses of the inflation objective?
2. Are the existing monetary policy tools adequate to achieve and
maintain maximum employment and price stability, or should the toolkit be
expanded?
3. How can the FOMC's communication of its policy framework and
implementation be improved?
I would like to spend a few minutes discussing the first topic. Because interest
rates around the world have steadily declined for several decades, rates in normal times
now tend to be much closer to zero than in the past (figure 5).8 Thus, when a recession
comes, the Fed is likely to have less capacity to cut interest rates to stimulate the
economy than in the past, suggesting that trips to the ELB may be more frequent. The
post-crisis period has seen many economies around the world stuck for an extended
period at the ELB, with slow growth and inflation well below target. Persistently weak
inflation could lead inflation expectations to drift downward, which would imply still
lower interest rates, leaving even less room for central banks to cut interest rates to
support the economy during a downturn. It is therefore very important for central banks
to find more effective ways to battle the low-inflation syndrome that seems to accompany
proximity to the ELB.
In the late 1990s, motivated by the Japanese experience with deflation and
sluggish economic performance, economists began developing the argument that a
central bank might substantially reduce the economic costs of ELB spells by adopting a
makeup strategy.9 The simplest version goes like this: If a spell with interest rates near
the ELB leads to a persistent shortfall of inflation relative to the central bank's goal, once
the ELB spell ends, the central bank would deliberately make up for the lost inflation by
stimulating the economy and temporarily pushing inflation modestly above the target. In
standard macroeconomic models, if households and businesses are confident that this
future inflationary stimulus will be coming, that prospect will promote anticipatory
consumption and investment. This can substantially reduce the economic costs of ELB
spells.10 Researchers have suggested many variations on makeup strategies.11 For
example, the central bank could target average inflation over time, implying that misses
on either side of the target would be offset.
By the time of the crisis, there was a well-established body of model-based
research suggesting that some kind of makeup policy could be beneficial.12 In light of
this research, one might ask why the Fed and other major central banks chose not to
pursue such a policy.13 The answer lies in the uncertain distance between models and
reality. For makeup strategies to achieve their stabilizing benefits, households and
businesses must be quite confident that the "makeup stimulus" is really coming. This
confidence is what prompts them to raise spending and investment in the midst of a
downturn. In models, confidence in the policy is merely an assumption. In practice,
10
Eggertsson and Woodford (2003), for example, show that optimal policy at the ELB entails a
commitment to reflate the price level during subsequent economic expansions. See also Wolman (2005)
for a discussion of the effectiveness of price-level targeting at the ELB. For a discussion of the relationship
between price-level targeting and average-inflation targeting, see Nessén and Vestin
(2005).
11
The strategy in Reifschneider and Williams (2000), for instance, involves a central bank following a
Taylor rule modified to make up for shortfalls in policy accommodation during ELB episodes. Kiley and
Roberts (2017) study a strategy in which policymakers aim for inflation higher than 2 percent during
normal times to compensate for below-target inflation during ELB episodes. See also Bernanke (2017) for
a strategy in which low inflation is made up if it occurs when the federal funds rate is at or near the ELB.
12
See, for example, English, López-Salido, and Tetlow (2015); Hebden and López-Salido (2018);
Bernanke, Kiley, and Roberts (2019); and Mertens and Williams (2019).
13
The Bank of Japan (2016) came closest, announcing in September 2016 an "inflation-overshooting
commitment" (p. 1). The commitment did not, however, come with any explicit goal for a degree or
duration of overshoot.
when policymakers considered these policies in the wake of the crisis, they had major
questions about whether a central bank's promise of good times to come would have
moved the hearts, minds, and pocketbooks of the public. Part of the problem is that when
the time comes to deliver the inflationary stimulus, that policy is likely to be unpopular--
what is known as the time consistency problem in economics.14
Experience in the United States and around the world suggests that more frequent
ELB episodes could prove quite costly in the future. My FOMC colleagues and I believe
that we have a responsibility to the American people to consider policies that might
promote significantly better economic outcomes. Makeup strategies are probably the
most prominent idea and deserve serious attention. They are largely untried, however,
and we have reason to question how they would perform in practice. Before they could
be successfully implemented, there would have to be widespread societal understanding
and acceptance--as I suggested, a high bar for any fundamental change. In this review,
we seek to start a discussion about makeup strategies and other policies that might
broadly benefit the American people.
Conclusion
Tonight I have focused on policy normalization and our efforts to engage the
public in what may come after. Before concluding, I will say a few words on current
conditions and the outlook.
Right now, most measures of the health and strength of the labor market look as
favorable as they have in many decades. Inflation will probably run a bit below our
objective for a time due to declines in energy prices, but those effects are likely to prove
transitory. Core inflation, which is often a reliable indicator of where inflation is headed
over time, is quite close to 2 percent. Despite this favorable picture, we have seen some
cross-currents in recent months. With nothing in the outlook demanding an immediate
policy response and particularly given muted inflation pressures, the Committee has
adopted a patient, wait-and-see approach to considering any alteration in the stance of
policy.
Considering monetary policy more broadly, we are inviting thorough public
scrutiny and are hoping to foster conversation regarding how the Fed can best exercise
the precious monetary policy independence we have been granted. Our goal is to
enhance the public's trust in the Federal Reserve--our most valuable asset.
References
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'Quantitative and Qualitative Monetary Easing with Yield Curve Control',"
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https://www.boj.or.jp/en/announcements/release_2016/k160921a.pdf.
Bernanke, Ben S. (2017). "Monetary Policy in a New Era," paper presented at
"Rethinking Macroeconomic Policy," a conference held at the Peterson Institute
of International Economics, Washington, October 12-13.
Bernanke, Ben S., Michael T. Kiley, and John M. Roberts (2019). "Monetary Policy
Strategies for a Low-Rate Environment," Finance and Economics Discussion
Series 2019-009. Washington: Board of Governors of the Federal Reserve
System, February, https://doi.org/10.17016/FEDS.2019.009.
Brand, Claus, Marcin Bielecki, and Adrian Penalver, eds. (2018). "The Natural Rate of
Interest: Estimates, Drivers, and Challenges to Monetary Policy," ECB
Occasional Paper Series No. 217. Frankfurt, Germany: European Central Bank,
December, https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op217.en.pdf.
Eggertsson, Gauti B., and Michael Woodford (2003). "The Zero Bound on Interest Rates
and Optimal Monetary Policy," Brookings Papers on Economic Activity, no. 1,
pp. 139-211,
https://www.brookings.edu/wpcontent/uploads/2003/01/2003a_bpea_eggertsson.pdf.
English, William B., J. David López-Salido, and Robert J. Tetlow (2015). "The Federal
Reserve's Framework for Monetary Policy: Recent Changes and New
Questions," IMF Economic Review, vol. 63 (April), pp. 22-70.
Friedman, Milton (1969). The Optimum Quantity of Money. New York: MacMillan.
Hebden, James, and J. David López-Salido (2018). "From Taylor's Rule to Bernanke's
Temporary Price Level Targeting," Finance and Economics Discussion Series
2018-051. Washington: Board of Governors of the Federal Reserve System,
July, https://doi.org/10.17016/FEDS.2018.051.
Holston, Kathryn, Thomas Laubach, and John C. Williams (2017). "Measuring the Natural
Rate of Interest: International Trends and Determinants," Journal of International
Economics, vol. 108 (May, Supplement 1), pp. S59-S75.
Kiley, Michael T., and John M. Roberts (2017), "Monetary Policy in a Low Interest Rate
World," Brookings Papers on Economic Activity, Spring, pp. 317-72,
https://www.brookings.edu/wp-content/uploads/2017/08/kileytextsp17bpea.pdf.
King, Mervyn, and David Low (2014). "Measuring the 'World' Real Interest Rate,"
NBER Working Paper Series 19887. Cambridge, Mass.: National Bureau of
Economic Research, February, https://www.nber.org/papers/w19887.pdf.
Mertens, Thomas M., and John C. Williams (2019). Monetary Policy Frameworks and
the Effective Lower Bound on Interest Rates, Staff Report 877. New York:
Federal Reserve Bank of New York, January,
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr877.pdf.
Nessén, Marianne, and David Vestin (2005). "Average Inflation Targeting," Journal of
Money, Credit and Banking, vol. 37 (October), pp. 837-63.
Rachel, Lukasz, and Thomas D. Smith (2017). "Are Low Real Interest Rates Here to
Stay?" International Journal of Central Banking, vol. 13 (September), pp. 1-42.
Reifschneider, David, and John C. Williams (2000), "Three Lessons for Monetary Policy
in a Low Inflation Era," Journal of Money, Credit and Banking, vol. 32
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Interest Rates," Journal of Money, Credit and Banking, vol. 37 (March),
pp. 273-96.
2029.
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y
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Table 1. Federal Reserve Liabilities as a Share of GDP
(Percent)
2006 2014 2019 2019 to 2006
Change
Reserve Balances 0.1 14.6 5.7 5.6
Currency in Circulation 5.5 7.1 7.9 2.4
Treasury General Account 0.0 0.6 1.4 1.4
Other Liabilities 0.3 2.5 1.4 1.1
Total Liabilities 5.9 24.8 16.5 10.6
Note: Values shown are averages for each liability item in Q4 of each year divided by Q4 nominal
GDP in that year. Values for 2019 are based on projections (for details on projections, see the
Figure 1 note). In this table, currency in circulation is Federal Reserve notes outstanding. Total
liabilities may not equal the sum of the line items due to rounding.
Source: Federal Reserve Board, Statistical Release H.4.1, "Factors Affecting Reserve Balances,"
https://www.federalreserve.gov/releases/h41; Federal Reserve Board staff calculations; Federal
Reserve Bank of New York Primary Dealer Survey and Survey of Market Participants;
Congressional Budget Office (2019), The Budget and Economic Outlook: 2019 to 2029 (Washington:
CBO), https://www.cbo.gov/system/files?file=2019-03/54918-Outlook-2.pdf.
Figure 2. Some Interesting Dots
Source: Steven Zucker. Seurat, A Sunday on La Grande Jatte-1884, detail with bouquet.
https://www.flickr.com/photos/profzucker/8018209742/in/photostream/
Figure 3. Georges Seurat's A Sunday Afternoon on the Island of La Grande
Jatte
Source: Wikimedia, https://upload.wikimedia.org/wikipedia/commons/6/67/A_Sunday_on_La_Grande_Jatte%2C_Georges
_Seurat%2C_1884.png.
Figure 4. Questions for the Review of Monetary Policy Strategy, Tools, and
Communications
1. Can the Federal Reserve best meet its statutory objectives with its existing monetary
policy strategy, or should it consider strategies that aim to reverse past misses of the
inflation objective?
2. Are the existing monetary policy tools adequate to achieve and maintain maximum
employment and price stability, or should the toolkit be expanded?
3. How can the FOMC's communication of its policy framework and implementation be
improved?
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