Donald L Kohn: Interactions between monetary and fiscal policy in the
current situation
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Conference on Monetary-Fiscal Policy Interactions, Expectations,
and Dynamics in the Current Economic Crisis, Princeton University, Princeton, New Jersey,
23 May 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Our current economic situation has altered some of the usual interactions between monetary
and fiscal policy. One change regards the relative effects of monetary and fiscal policy. The
depth and persistence of economic weakness has meant that traditional monetary policy -
the target for the federal funds rate - has become constrained from easing as much as might
be desirable under the circumstances, and, as a consequence, the target federal funds rate
is anticipated to remain near zero for some time. But as a result, fiscal stimulus has
potentially become more effective in boosting economic activity than it usually would be.
Another change involves the potential for monetary policy actions to have greater fiscal
implications than usual. The Federal Reserve has extended both its open market operations
and lending programs in unprecedented ways to ease financial conditions and to help revive
economic activity. In our open market operations, we have embarked on large-scale
purchases of intermediate- and long-term Treasury securities, agency debt, and
agencyguaranteed mortgage-backed securities (MBS) in order to put further downward pressure on
borrowing costs, greatly increasing the degree of maturity transformation on our balance
sheet. In addition, our traditional liquidity operations have been extended to include new
borrowers and new markets, with the potential for greater credit risk than usual.
In my view, our nontraditional policy actions have been necessary to avert a far worse
economic outcome, and they remain consistent with the traditional goals and principles of
monetary policy. Moreover, as I will be discussing, we have structured these policies with the
aim of accomplishing our objectives with few, if any, fiscal consequences. I will conclude with
some thoughts about the transition back toward more typical monetary policy as the
economy and financial markets improve.1
Fiscal policy when monetary policy is at the zero lower bound
During normal economic circumstances, most economists do not view expansionary fiscal
policy as an especially effective tool for producing a sustained increase in aggregate demand
and in resource utilization. Ordinarily, financial market participants would expect monetary
policy to react by increasing the target federal funds rate over time to keep output near
potential and inflation near its desired level. Thus, the enactment of a sustained fiscal
expansion would trigger an increase in expected short-term interest rates and hence
longterm interest rates. The higher long-term rates would also tend to reduce asset values and
boost the foreign exchange value of the dollar. As a result, any initial increase in aggregate
output and employment from the fiscal expansion would be soon crowded out by reductions
in household spending, business investment, and net exports.2
But in the current weak economic environment, a fiscal expansion may be much more
effective in providing a sustained boost to economic activity. With traditional monetary policy
currently constrained from further reductions in the target policy rate, and with many analysts
forecasting lower-than-desired inflation and a persistent, large output gap, agents may
anticipate that the target federal funds rate will remain near zero for an extended period. In
this situation, fiscal stimulus could lead to a considerably smaller increase in long-term
interest rates and the foreign exchange value of the dollar, and to smaller decreases in asset
prices, than under more normal circumstances. Indeed, if market participants anticipate the
expansionary fiscal policy to be relatively temporary, and the period of weak economic
activity and constrained traditional monetary policy to be relatively extended, they may not
expect any increase in short-term interest rates for quite some time, thus damping any rise in
long-term interest rates. Moreover, if the initial boost to aggregate spending from fiscal
stimulus raises inflation expectations, then real short-term interest rates would tend to
decline, given that the nominal short-term interest rate is constrained at the zero lower
bound. All told, the result is likely to be considerably less of the usual crowding out of fiscal
stimulus in these circumstances, thereby increasing the effectiveness of fiscal policy to boost
the level of aggregate economic activity in the short to medium term.
This scenario is supported by simulations using the Federal Reserve staff's FRB/US model,
assuming all agents have rational expectations.3 For example, suppose the level of federal
government purchases is increased permanently by 1 percent of gross domestic product
(GDP). Under normal circumstances, the fiscal spending multiplier - that is, the percentage
response of real GDP to the boost in government spending - starts out at about 1 but then
quickly falls to zero as long-term interest rates rise so that private spending and exports
decline. However, if financial market participants anticipate that the federal funds rate will
remain at zero for an appreciable period of time following the hike in government spending,
the simulated short-run fiscal multiplier rises to 1.3 for some time. Model simulations also
indicate that the fiscal spending multiplier may rise even further - to around 2 - if the fiscal
stimulus is expected to be temporary and to last no longer than the period when monetary
policy holds short-term interest rates at the zero lower bound.4
To be sure, greater-than-usual uncertainty surrounds estimates of the size of the fiscal
multiplier under current circumstances, and its magnitude could be somewhat smaller than
suggested by these model simulations. With lenders unusually cautious, household and
business spending may react less than would normally be expected to low real interest rates
because tight nonprice credit terms are restricting access to borrowed funds. Also, the
above-normal levels of uncertainty faced by households and firms could damp the
responsiveness of consumption and investment spending to the boost in household income
and business earnings generated by the fiscal stimulus. Finally, any increase in uncertainty
about the longer-term trajectory of government borrowing could raise term premiums.
2
Of course, sustained changes in fiscal policy may have supply-side implications that affect the long-run level
of potential output, and hence actual gross domestic product. Except to the extent that these long-run changes
alter the equilibrium real rate of interest, however, they have only minor implications for monetary policy.
3
In the FRB/US model, about 40 percent of households are estimated to be rule-of-thumb consumers, implying
that they generally spend most of their current income. The remaining households are life-cycle consumers,
implying that their spending decisions are influenced by their expected permanent income rather than their
current income. However, these consumers are nonetheless relatively sensitive to expected changes in
income over the next several years because they are assumed to discount future income at a high rate,
reflecting its uncertain nature.
4
These basic results are also borne out by simulations using the Federal Reserve staff's estimated dynamic
stochastic general equilibrium (DSGE) model of the U.S. economy, EDO, and its calibrated multicountry
DSGE model, SIGMA.
BIS Review 63/2009
Nontraditional monetary policies
Current economic and financial conditions have not only changed the potential effectiveness
of fiscal stimulus, but they also have altered the way in which monetary policy seeks to
support economic activity and foster price stability. With the target federal funds rate
effectively at zero, our traditional monetary policy tool can no longer provide additional
stimulus to the economy. Moreover, heightened uncertainty and pressures on intermediary
balance sheets have impaired the usual channels of credit intermediation. In these
circumstances, the Federal Reserve has provided additional monetary stimulus by easing
financial conditions more directly through its interventions in a variety of financial markets. In
effect, we have stepped up our intermediation by making large volumes of asset purchases
and loans, which have been associated with a very substantial increase in bank reserves on
the liability side of our balance sheet.
In open market operations, we have announced our intention to purchase up to $1.75 trillion
in longer-term Treasury notes and bonds, agency debt, and agency MBS during this year.
This program is intended to stimulate real economic activity by holding down intermediate-
and long-term interest rates by bringing down the term premium on these securities - a
mechanism that is distinct from the traditional channel whereby a shift in the stance of
monetary policy affects longer-term yields by changing the expected path of short-term
interest rates.5 The preliminary evidence suggests that our program so far has worked; for
example, our announcements regarding the large-scale asset purchase program coincided
with cumulative restraint on the average level of longer-term interest rates, perhaps by as
much as 100 basis points by some estimates.
That the Federal Reserve is holding a portfolio of long-term assets on its books is not
especially unusual - prior to the onset of the financial crisis, we held about $150 billion of
Treasury securities with maturities of more than five years. Moreover, we have long been
authorized to purchase securities issued by government-sponsored enterprises (GSEs).
However, in the current circumstance, the scale of our intended holdings, and the related
expansion of the Fed's liabilities to acquire these assets, is unprecedented. Holding such a
large portfolio of long-term assets does expose the Federal Reserve, and thus the taxpayer,
to potential losses as short-term interest rates rise. We could end up financing our holdings
of some low-yielding long-term assets with more expensive short-term liabilities or, we might
have to sell some of these assets at a loss as long-term rates rise. But in gauging the
potential cost to taxpayers associated with future interest rate movements, several
considerations are important to keep in mind. First, some of the Treasury and GSE debt that
we are acquiring will run off over the next few years without any need for outright sales, as
will some of the MBS as individuals sell or refinance their homes. Second, the yield curve
currently has a steep upward slope. Accordingly, we are now earning an abnormally high net
rate of return by funding our acquisition of long-term assets with almost zero-cost excess
reserves - and this relative yield relationship is likely to last for some time. Thus, in judging
the potential budget cost over time, any possible future interest-rate-related losses need to
be balanced against the current elevated level of our net interest income. Third, our
purchases of long-term securities are boosting economic activity and, in the process,
increasing government tax receipts relative to what they would have been in the absence of
such purchases.6 All in all, although we have now taken more interest rate risk onto our
balance sheet than usual (at a time when the private sector wants to avoid this risk), that
action may boost, rather than reduce, the cumulative net income of the Treasury.
Turning to our credit facilities, our usual lending through the discount window has been
extended to new intermediaries - including primary dealers, money market mutual funds,
and participants in securitization markets such as hedge funds and pension funds. And we
have intervened more directly in severely impaired markets, such as those for commercial
paper and securitized consumer and mortgage debt. We believe these interventions have
been successful in supporting economic growth by bringing down interest rates on the
instruments involved, preventing fire sales of assets by intermediaries that would otherwise
not have access to liquidity, and facilitating new lending.
These unusual extensions of our lending facilities have raised concerns about the Federal
Reserve taking on credit risk. While those concerns are understandable, I want to emphasize
that we have taken a variety of steps to minimize credit risk in setting up the various
nontraditional and temporary credit facilities that we have made available to a number of new
borrowers. For almost all the loans we have made, we look first to sound borrowers for
repayment and then to underlying collateral. Moreover, we lend less than the value of the
collateral, with the size of the "haircuts" depending on the riskiness of the collateral and on
the availability of market prices for the collateral. Some of our lending programs involve
nonrecourse loans that look primarily to the collateral rather than to the borrower for
repayment. In these instances, we typically have taken only the highest-quality collateral,
and, in many cases, we have coordinated with the Treasury to have other sources available
to absorb any losses that might nonetheless occur. An example of a program that relies
importantly on monetary-fiscal coordination is the Term Asset-Backed Securities Loan
Facility, whereby protection against credit risk takes the form of capital provided by the
Treasury, using funds appropriated by the Congress for the Troubled Asset Relief Program.
To be sure, loans or credit protection offered in association with government help to stabilize
individual systemically important institutions likely have higher credit risk than our more
general liquidity facilities. But even in these few cases, which occurred under emergency
conditions, we have taken steps to protect the Federal Reserve from credit losses and have
asked the Treasury to take these loans off our balance sheet. To reduce the risk of future
problems here, a new regulatory regime should be developed that will allow the U.S.
government to address effectively at an early stage the potential failure of any systemically
critical financial institution.
Finally, there is the question of whether the Federal Reserve has become involved in the
inherently fiscal function of allocating credit to specific sectors of the economy. Because of
the lack of liquidity, risk-taking, and arbitrage in markets, we have been forced to counter
tight financial conditions through interventions in particular markets, which can have
differential effects. But our actions have been aimed at increasing credit flows for the entire
economy, and they have been effective in that regard. For example, our large-scale asset
purchases of agency securities and agency-guaranteed MBS have helped mortgage
markets, but they also appear to have put downward pressure on other long-term interest
rates, as we expected. Similarly, our other efforts to supply liquidity to the financial system
have been intended to be broad based, helping banks, investment banks, and money market
mutual funds perform their intermediary functions and helping restart widely utilized
securitization markets.
Both the Treasury and the Federal Reserve understand, and have acknowledged in the joint
statement released on March 23, that it is important for the Federal Reserve to avoid credit
risk and credit allocation.7 Our lender-of-last-resort responsibilities should only involve
lending that is appropriately secured. Actions taken by the Federal Reserve should also aim
to improve financial and credit conditions broadly and not to allocate credit to narrowly
defined sectors or classes of borrowers, as any decisions to influence the allocation of credit
is the role of fiscal policy. Moreover, I believe the essential role for an independent monetary
policy authority pursuing financial stability, economic growth, and price stability remains
widely appreciated. Indeed, the joint statement of the Treasury and the Federal Reserve also
included an agreement to continue to pursue additional tools to control our balance sheet to
reinforce our ability to conduct an independent policy in pursuit of our macroeconomic
objectives - the final topic that I will discuss today.
Transition back to more traditional monetary policy
An important issue with our nontraditional policies is the transition back to a more normal
stance and operations of monetary policy as financial conditions improve and economic
activity picks up enough to increase resource utilization. These actions will be critical to
ensuring price stability as the real economy returns to normal. The decision about the timing
of a turnaround in policy will be similar to that faced by the Federal Open Market Committee
(FOMC) in every cyclical downturn - it has to choose when, and how quickly, to start raising
the federal funds rate. In the current circumstances, the difference will be that we will have to
start this process with an unusually large and more extended balance sheet.
In my view, the economy is only now beginning to show signs that it might be stabilizing, and
the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial
intermediaries and households. As a consequence, it probably will be some time before the
FOMC will need to begin to raise its target for the federal funds rate. Nonetheless, to ensure
confidence in our ability to sustain price stability, we need to have a framework for managing
our balance sheet when it is time to move to contain inflation pressures.
Our expanded liquidity facilities have been explicitly designed to wind down as conditions in
financial markets return to normal, because the costs of using these facilities are set higher
than would typically prevail in private markets during more usual times. Indeed, some of our
emergency facilities - the Term Securities Lending Facility and the Primary Dealer Credit
Facility - have already seen reduced use as funding markets have returned to more normal
functioning. Managing the assets acquired under our large-scale asset purchase program will
require a different set of techniques. As I have already noted, some portion of these assets
will run off on their own. In addition, we can actively manage the asset levels down by selling
the assets outright or on a temporary basis through reverse-repurchase transactions.
Moreover, we could run off these holdings slowly while still raising the federal funds rate if we
increased the rate paid on excess reserves held at the Federal Reserve. In principle, the rate
paid on excess reserves should act as a floor on the federal funds rate; although recent
experience suggests that it may not establish a hard floor, that experience has been
influenced by the unwillingness of banks to arbitrage in size in the current circumstances
when they are worried about their capital. Finally, as I've already noted, the Administration
has said it will work with us and the Congress to get us an additional tool for absorbing
reserves.
Conclusion
Experiences studied over a range of countries and periods of history tell us that central
banks need a degree of insulation from short-term political pressures if they are to
consistently foster the achievement of their medium-term macroeconomic objectives of price
stability and high employment. This independence in the conduct of monetary policy has
been supported by minimizing the fiscal implications of monetary policy operations. The
Federal Reserve has attempted to maintain this separation while extending the range of our
open market operations and discount window lending. But changing policy interaction and
greater cooperation between fiscal and monetary authorities have been an inevitable aspect
of effective policy initiatives to meet our macroeconomic objectives in the current financial
and economic crises. As the economic recovery takes hold, we will need to return to more
normal modes of operation - a circumstance this central banker is very much looking forward
to.