Janet L Yellen: Challenges confronting monetary policy
Speech by Ms Janet L Yellen, Vice Chair of the Board of Governors of the Federal Reserve
System, at the 2013 National Association for Business Economics Policy Conference,
Washington DC, 4 March 2013.
* * *
Thank you. I'm delighted to address the National Association for Business Economics
(NABE), a group that has done so much to promote understanding of the economy and the
appropriate role of policy.
My topic today is the challenges confronting monetary policy in what has been an unusually
weak recovery from a severe recession. I will discuss the Federal Reserve's ongoing efforts
in these circumstances to speed the U.S. economy's return to maximum employment in a
context of price stability.1
As you know, the Federal Open Market Committee (FOMC) has recently taken new steps to
achieve this objective. In September, the Committee approved a new program of
agencyguaranteed mortgage-backed securities (MBS) purchases, pledging to continue the program
- contingent on favorable ongoing evaluations of its efficacy and costs - until there has been
a substantial improvement in the outlook for the labor market.2 Most recently, in December
the Committee announced that it would purchase longer-term Treasury securities after
completion of the maturity extension program. At the same time, it revamped its forward
guidance for the federal funds rate, explicitly linking the path of that rate to quantitative
measures of economic performance.3
My goal today is to explain these policies and why I consider them appropriate under current
conditions. With respect to the asset purchase program, I will discuss several economic
indicators that I plan to consider in evaluating the outlook for the labor market and then offer
my perspective at present on the program's efficacy and costs, an assessment I will continue
updating in light of experience.
The outlook for the labor market and inflation
The Committee's recent actions are shaped by the fact that the labor market is still far from
healed from the trauma of the Great Recession. Despite some welcome improvement,
employment remains well below its pre-recession peak, reflecting an economy that is still
operating far short of its potential. At 7.9 percent in January, the unemployment rate has
declined from its recent peak of 10 percent in October 2009. But that's still higher than
unemployment ever reached in the 24 years prior to the recent recession and well above the
5.2 to 6 percent that is the central tendency of FOMC participants' estimates of the
longerrun normal rate of unemployment. With economic activity constrained by fiscal consolidation,
the lingering effects from the financial crisis, and the added headwinds of Europe's recession
and debt problems, most FOMC participants reported in December that they expected only a
gradual decline in unemployment over the next two years, to about 7 percent by the end of
2014.4
The official estimate of 12 million currently unemployed does not include 800,000 more
discouraged workers who say they have given up looking for work.5 In addition, nearly
8 million people, or 5.6 percent of the workforce, say they are working part time even though
they would prefer full-time jobs. A broader measure of underemployment that includes these
and others who want a job stands at 14.4 percent, nearly double the 7.9 percent "headline"
rate that is most commonly reported in the media.6
The large shortfall of employment relative to its maximum level has imposed huge burdens
on all too many American households and represents a substantial social cost. In addition,
prolonged economic weakness could harm the economy's productive potential for years to
come. The long-term unemployed can see their skills erode, making these workers less
attractive to employers. If these jobless workers were to become less employable, the natural
rate of unemployment might rise or, to the extent that they leave the labor force, we could
see a persistently lower rate of labor force participation. In addition, the slow recovery has
depressed the pace of capital accumulation, and it may also have hindered new business
formation and innovation, developments that would have an adverse effect on structural
productivity.
In contrast to the large gap between actual and maximum employment, inflation, apart from
fluctuations due to energy and other commodity prices, has been running for some time now
a little below the rate of 2 percent per year that the Committee judges to be consistent with
the Federal Reserve's dual mandate. The Committee anticipates that inflation will continue to
run at or below 2 percent over the medium term. Moreover, expectations for inflation over the
next 5 to 10 years remain well anchored, according to surveys of households and
professional forecasters.
With employment so far from its maximum level and with inflation running below the
Committee's 2 percent objective, I believe it's appropriate for progress in the labor market to
take center stage in the conduct of monetary policy. Let me therefore turn to the FOMC's
recent actions and describe how I see them promoting this important goal.
Forward guidance for the federal funds rate
I'll begin with the Committee's forward guidance for the federal funds rate. The FOMC has
employed such forward guidance since 2003 but has relied more heavily on it since
December 2008, when the target for the federal funds rate was reduced to its effective lower
bound. In current circumstances, forward guidance can lower private-sector expectations
regarding the future path of short-term rates, thereby reducing longer-term interest rates on a
wide range of debt instruments and also raising asset prices, leading to more
accommodative financial conditions. In addition, given the FOMC's stated intention to sell
4
In the December 2012 Summary of Economic Projections (SEP), the central tendency of FOMC participants'
projections for the unemployment rate in the final quarter of 2013 and 2014 was 7.4 to 7.7 percent and 6.8 to
7.3 percent, respectively. The central tendency omits the three lowest and three highest projections. The SEP
is an addendum to the FOMC minutes and is available at Board of Governors (2013).
5
The most widely reported estimate of those in the labor force who are unemployed - 12.3 million in January,
rounded to 12 million, from the Bureau of Labor Statistics (BLS) - is seasonally adjusted. (Without seasonal
adjustment, the actual estimate of unemployed in January was 13.2 million.) The BLS does not seasonally
adjust its estimate of discouraged workers who have left the labor force, an estimate that was 804,000 in
January. For more on the employment situation in January, see Bureau of Labor Statistics (2013).
6
In my view, and as I've argued elsewhere (Yellen, 2013), the evidence indicates that elevated unemployment
and the disappointingly slow improvement in the labor market are primarily the result of weak aggregate
demand and not an increase in structural unemployment.
assets only after the federal funds rate target is increased, any outward shift in the expected
date of liftoff for the federal funds rate suggests that the Federal Reserve will be holding a
large stock of assets on its balance sheet longer, which should work to further increase
accommodation.7
Starting in March 2009, the FOMC's postmeeting statements noted that "economic
conditions are likely to warrant exceptionally low levels of the federal funds rate for an
extended period," and in November of the same year added "low rates of resource utilization,
subdued inflation trends, and stable inflation expectations" as justification for this stance."8 In
August 2011, the Committee substituted "at least through mid-2013" for the words "for an
extended period."9 This date was moved further into the future several times, most recently
last September, when it was shifted to mid-2015.10 Also in September, the Committee
changed the language related to that commitment, dropping the reference to "low rates of
resource utilization and a subdued outlook for inflation." Instead, it emphasized that "a highly
accommodative stance of monetary policy will remain appropriate for a considerable time
after the economic recovery strengthens," clarifying the Committee's intention to continue to
provide support well into the recovery.11
Finally, last December, the Committee recast its forward guidance for the federal funds rate
by specifying a set of quantitative economic conditions that would warrant holding the federal
funds rate at the effective lower bound. Specifically, the Committee anticipates that
exceptionally low levels for the federal funds rate will be appropriate "at least as long as the
unemployment rate remains above 6-1/2 percent, inflation between one and two years
ahead is projected to be no more than a half percentage point above the Committee's
2 percent longer-run goal, and longer-term inflation expectations continue to be well
anchored."12
An important objective of these changes in forward guidance is to enhance the public's
understanding of the Committee's policy strategy and its "reaction function" - namely, how
the FOMC anticipates varying its federal funds rate target in response to evolving economic
developments. For example, the Committee's initial, calendar-based guidance did not clearly
convey the rationale for the specified date. In particular, when the Committee extended the
calendar date, the public was left to infer whether the change reflected a deterioration in the
Committee's economic outlook or, instead, a decision to increase policy accommodation.
In my view, the language now incorporated into the statement affirmatively conveys the
Committee's determination to keep monetary policy highly accommodative until well into the
recovery. And the specific numbers that were selected as thresholds for a possible change in
the federal funds rate target should confirm that the FOMC expects to hold that target lower
for longer than would be typical during a normal economic recovery. This improved guidance
should help the public to accurately adjust their expectations for the federal funds rate in
response to new financial and economic information, which should make policy more
effective.13 In addition, I hope that improved guidance will help to boost confidence in the
7
Empirical studies of the Committee's date-based forward guidance suggest that changes in that guidance
generated an appreciable effect on longer-term yields. See, for example, Swanson and Williams (2012) and
Woodford (2012).
8
See Board of Governors (2009a, 2009b).
9
See Board of Governors (2011a).
10
See Board of Governors (2012a).
11
See Board of Governors (2012a).
12
See Board of Governors (2012b).
13
The new guidance should serve as an automatic stabilizer in the face of shifts in the outlook. For example,
weaker economic data, suggesting that the thresholds will be reached later than previously anticipated, should
outlook and bolster households' unusually depressed expectations for income gains, which in
turn will spur a faster recovery.
A considerable body of research suggests that, in normal times, the evolution of the federal
funds rate target can be reasonably well described by some variant of the widely known
Taylor rule.14 Rules of this type have been shown to work quite well as guidelines for policy
under normal conditions, and they are familiar to market participants, helping them judge
how short-term rates are likely to respond to changing economic conditions.
The current situation, however, is abnormal in two important and related ways. First, in the
aftermath of the financial crisis, there has been an unusually large and persistent shortfall in
aggregate demand. Second, use of the federal funds rate has been constrained by the
effective lower bound so that monetary policy has been unable to provide as much
accommodation as conventional policy rules suggest would be appropriate, given the
weakness in aggregate demand. I've previously argued that, in such circumstances, optimal
policy prescriptions for the federal funds rate's path diverge notably from those of standard
rules.15 For example, David Reifschneider and John Williams have shown that when policy is
constrained by the effective lower bound, policymakers can achieve superior economic
outcomes by committing to keep the federal funds rate lower for longer than would be called
for by the interest rate rules that serve as reasonably reliable guides for monetary policy in
more normal times.16 Committing to keep the federal funds rate lower for longer helps bring
down longer-term interest rates immediately and thereby helps compensate for the inability
of policymakers to lower short-term rates as much as simple rules would call for.
I view the Committee's current rate guidance as embodying exactly such a "lower for longer"
commitment. In normal times, the FOMC would be expected to tighten monetary policy
before unemployment fell as low as 6-1/2 percent. Under the new thresholds guidance, the
public is informed that tightening is unlikely as long as unemployment remains above
6-1/2 percent and inflation one to two years out is projected to be no more than a half
percentage point above the FOMC's 2 percent longer-run goal.17 The evidence suggests that
the evolution I've described in the Committee's forward guidance, particularly the new
has
thresholds, shifted the market's view of how forceful the FOMC intends to be in
supporting the recovery. In the Federal Reserve Bank of New York's Survey of Primary
Dealers, for example, participants have repeatedly revised downward the unemployment rate
at which they anticipate that tightening will first occur.18
I mentioned that the FOMC's new forward guidance offers considerable insight into the
Committee's likely reaction function, but I should note that the guidance it provides is not
complete. For example, the Committee has not specified exactly how it intends to vary the
federal funds rate after liftoff from the effective lower bound, although it has stated that "when
the Committee decides to begin to remove policy accommodation, it will take a balanced
approach."19 This language is consistent with optimal policy prescriptions that call for lower-
lead market participants to push out the expected timing of liftoff, automatically promoting lower longer-term
rates and an easing of financial conditions. See, for example, Yellen (2012b).
14
See, for example, Clarida, Galí, and Gertler (2000) and Rudebusch (2006).
15
See, for example, Yellen (2012a, 2012b).
16
See Reifschneider and Williams (2000).
17
Setting the threshold above the unemployment rate's longer-run normal level recognizes the fact that
monetary policy affects real activity and inflation with a lag so that, assuming inflation is near the Committee's
long-run target, it will likely be necessary to begin the process of removing accommodation before the
longerrun normal rate is reached.
18
The Survey of Primary Dealers is available on the Federal Reserve Bank of New York's website.
19
See Board of Governors (2012b).
for-longer considerations to pertain to the path of the federal funds rate both before and after
liftoff.
In addition, the guidance specifies thresholds for possible action, not triggers that will
necessarily prompt an increase in the federal funds rate. The FOMC statement therefore
notes that "in determining how long to maintain a highly accommodative stance of monetary
policy, the Committee will also consider other information, including additional measures of
labor market conditions, indicators of inflation pressures and inflation expectations, and
readings on financial developments."20
For example, the Committee could decide to defer action even after the unemployment rate
has declined below 6-1/2 percent if inflation is running and expected to continue at a rate
significantly below the Committee's 2 percent objective. Alternatively, the Committee might
judge that the unemployment rate significantly understates the actual degree of labor market
slack. A decline in the unemployment rate could, for example, primarily reflect the exit from
the labor force of discouraged job seekers. That is an important reason why the Committee
will consider a broad range of labor market indicators. I will discuss some of the additional
indicators I plan to consider in judging the strength of the labor market in connection with the
Committee's current asset purchase program.
The Federal Reserve's asset purchase program
Turning next to that program, the Federal Reserve initiated a new asset purchase program
last September, extending it in December, under which the Federal Reserve is currently
buying agency-guaranteed MBS at a pace of $40 billion per month and longer-term Treasury
securities at a pace of $45 billion per month. As with the guidance for the federal funds rate,
the Committee tied the new program to labor market conditions, stating that purchases would
continue until there is a substantial improvement in the outlook for the labor market in a
context of price stability.21 The FOMC's earlier large-scale asset purchase programs, in
contrast, were fixed in size and carried out on a specified schedule. The Committee has also
noted that, in determining the size, pace, and composition of its asset purchases, it would
take appropriate account of the likely efficacy and costs of such purchases.
The purpose of the new asset purchase program is to foster a stronger economic recovery,
or, put differently, to help the economy attain "escape velocity." By lowering longer-term
interest rates, these asset purchases are expected to spur spending, particularly on
interestsensitive purchases such as homes, cars, and other consumer durables. Research on the
effects of such asset purchases suggests that what matters for the reaction of longer-term
interest rates to a purchase program is the extent to which the program leads market
participants to change their expectations concerning the entire path of the Federal Reserve's
holdings of longer-term securities.22 Other things being equal, the greater the effect that a
purchase program has on the expected path of the Federal Reserve's securities holdings,
the more substantial should be the downward pressure on the term premium in longer-term
interest rates.23 By linking the pace of purchases and how long that pace will be maintained
to the outlook for the labor market, the program acts as a sort of automatic stabilizer: As
market perceptions of the prospects for the economy vary, so too should expectations of the
pace and duration of asset purchases.
In stating that asset purchases will continue, subject to caveats pertaining to efficacy and
costs, until there has been a substantial improvement in the outlook for the labor market, the
FOMC established a criterion that differs in three important respects from the forward
guidance for the federal funds rate: (1) It is qualitative, not quantitative; (2) it refers to an
improvement in the outlook for the labor market rather than an improvement in actual labor
market conditions; and (3) it requires the Committee not only to consider progress toward its
employment goal, but also to evaluate the efficacy and costs of asset purchases on an
ongoing basis. The public is, naturally, eager to understand how the FOMC will approach
such complex judgments. I cannot, of course, speak for the Committee on this issue, but I
can spell out some of the key factors that will guide my conclusions.
A "Substantial improvement in the outlook for the labor market"
The first imperative will be to judge what constitutes a substantial improvement in the outlook
for the labor market. Federal Reserve research concludes that the unemployment rate is
probably the best single indicator of current labor market conditions. In addition, it is a good
predictor of future labor market developments. Since 1978, periods during which the
unemployment rate declined 1/2 percentage point or more over two quarters were followed
by further declines over the subsequent two quarters about 75 percent of the time.
That said, the unemployment rate also has its limitations. As I noted before, the
unemployment rate may decline for reasons other than improved labor demand, such as
when workers become discouraged and drop out of the labor force. In addition, while
movements in the rate tend to be fairly persistent, recent history provides several cases in
which the unemployment rate fell substantially and then stabilized at still-elevated levels. For
example, between the fourth quarter of 2010 and the first quarter of 2011, the unemployment
rate fell 1/2 percentage point but was then little changed over the next two quarters.
Similarly, the unemployment rate fell 3/4 percentage point between the third quarter of 2011
and the first quarter of 2012, only to level off over the subsequent spring and summer.
To judge whether there has been a substantial improvement in the outlook for the labor
market, I therefore expect to consider additional labor market indicators along with the overall
outlook for economic growth. For example, the pace of payroll employment growth is highly
correlated with a diverse set of labor market indicators, and a decline in unemployment is
more likely to signal genuine improvement in the labor market when it is combined with a
healthy pace of job gains.
The payroll employment data, however, also have shortcomings. In particular, they are
subject to substantial revision. When the Labor Department released its annual
benchmarking of the establishment survey data last month, it revised up its estimate of
employment in December 2012 by 647,000.
In addition, I am likely to supplement the data on employment and unemployment with
measures of gross job flows, such as job loss and hiring, which describe the underlying
dynamics of the labor market. For instance, layoffs and discharges as a share of total
employment have already returned to their pre-recession level, while the hiring rate remains
depressed. Therefore, going forward, I would look for an increase in the rate of hiring.
Similarly, a pickup in the quit rate, which also remains at a low level, would signal that
workers perceive that their chances to be rehired are good - in other words, that labor
demand has strengthened.
I also intend to consider my forecast of the overall pace of spending and growth in the
economy. A decline in unemployment, when it is not accompanied by sufficiently strong
growth, may not indicate a substantial improvement in the labor market outlook. Similarly, a
convincing pickup in growth that is expected to be sustained could prompt a determination
that the outlook for the labor market had substantially improved even absent any substantial
decline at that point in the unemployment rate.
The efficacy of asset purchases
Let me turn next to the efficacy and potential costs of asset purchases, a topic discussed at
recent FOMC meetings and that I suspect will be discussed at succeeding meetings as well.
I see the currently available evidence as suggesting that our asset purchases have been
reasonably efficacious in stimulating spending. There is considerable evidence that these
purchases have eased financial conditions, and so have presumably increased
interestsensitive spending.24 Research suggests that our purchases of mortgage-backed securities
pushed down MBS yields and that MBS yields pass through, with a lag, to mortgage rates.25
Indeed, I see the recent strength in housing and consumer durables, such as motor vehicle
purchases, as partly reflecting the effect of reduced borrowing costs. Plausible, albeit
uncertain, estimates of the ultimate economic effect of asset purchases can be obtained from
simulations of the Board's FRB/US model. Such simulations suggest that a hypothetical
program involving $500 billion in longer-term asset purchases would serve to lower the
unemployment rate by close to 1/4 percentage point within three years while keeping inflation
close to the Committee's 2 percent objective.
One issue on which there has been considerable debate is whether low interest rates are
doing as much to promote economic growth since the financial crisis as they would have
before the financial crisis - whether the interest rate channel of transmission for monetary
policy has been attenuated. I agree with those who think this channel has been partially
blocked. Individuals who have impaired credit histories, have been unemployed, or hold
underwater mortgages are experiencing great difficulty gaining access to credit, whether to
buy or refinance a home, finance a small business, or support spending for other needs.
Even those with good, but not stellar, credit histories and sufficient income are facing
capacity constraints in the mortgage market. However, even if the interest rate channel is
less powerful right now than it was before the crisis, asset purchases still work to support
economic growth through other channels, including by boosting stock prices and house
values. The resulting improvement in household wealth supports greater consumption
spending.
The costs of asset purchases
Turning to the potential costs of the Federal Reserve's asset purchases, there are some that
definitely need to be monitored over time. At this stage, I do not see any that would cause
me to advocate a curtailment of our purchase program.
To address one concern that I have heard, there is no evidence that the Federal Reserve's
purchases have impaired the functioning of financial markets, and, while we continue to
monitor market function carefully, so long as we pursue our purchases sensibly, I do not
expect market functioning to become a problem in the future. Further, I've argued previously,
and still judge, that the FOMC has the tools it needs to withdraw accommodation, even if the
balance sheet at that time is large. These tools include a new one, approved by the
Congress during the financial crisis, which allows the Federal Reserve to pay banks interest
on their reserves. A suite of supporting tools, such as reverse repurchase agreements with a
wide range of counterparties and the Term Deposit Facility, are routinely tested to make sure
that the Federal Reserve is prepared to use them and that they will work as planned.
Two additional costs have been discussed at recent meetings of the FOMC. First, the
expansion of the balance sheet has implications for the Federal Reserve's earnings from its
asset holdings and, hence, for its remittances to the Treasury. Second, some have raised the
possibility that the Committee's policies could have negative consequences for financial
stability.
With respect to the Federal Reserve's remittances, balance sheet operations are intended to
support economic growth and job creation in a context of price stability and not to maximize
Federal Reserve income. There is a possibility that the Federal Reserve's earnings from its
assets and the remittances of those earnings to the Treasury will decline later in the decade,
perhaps even ceasing entirely for some period. It is important to note, however, that any
losses that could conceivably occur would not impair the Federal Reserve's conduct of
monetary policy.26 Further, even if remittances to the Treasury ceased for a time, it is highly
likely that average annual remittances over the period affected by our asset purchases will
be higher than the pre-crisis norms.
Though our expanded portfolio of longer-term securities has in recent years translated into
substantial earnings and remittances to the Treasury, the Federal Reserve has, to be sure,
increased its exposure to interest rate risk by lengthening the average maturity of its
securities holdings. As the economic recovery strengthens and monetary policy normalizes,
the Federal Reserve's net interest income will likely decline. In particular, the Federal
Reserve's interest expenses will increase as short-term interest rates rise, while reserve
balances initially remain sizable. In addition, policy normalization may well involve significant
sales of the Federal Reserve's agency securities holdings, and losses could be incurred in
these sales. A recent study by the Board staff considered the effect of a number of scenarios
on Federal Reserve income, based on assumptions about the course of balance sheet
normalization that are consistent with the exit strategy principles adopted at the June 2011
FOMC meeting.27
The projections resulting from this exercise imply that Federal Reserve remittances to the
Treasury will likely decline for a time. In some scenarios, they decline to zero. Once the
Federal Reserve's portfolio is normalized, however, earnings are projected to return to their
long-run trend. The study supports the conclusion that the Federal Reserve's purchase
programs will very likely prove to have been a net plus for cumulative income and
remittances to the Treasury over the period from 2008 through 2025, by which time it is
assumed that the balance sheet has been normalized.28
Focusing only on the ebb and flow of the Federal Reserve's remittances to the Treasury,
however, is not, in my view, the appropriate way to evaluate the effect of these purchases on
the government's finances. More germane is the overall effect of the program on federal
finances. If the purchases provide even a modest boost to economic activity, increased tax
payments would swamp any reduction in remittances. By depressing longer-term interest
rates, the purchases also hold down the Treasury's debt service costs. These effects can be
quantified through simulations of the Board's FRB/US model. In the simulation I described
earlier, a hypothetical program involving $500 billion of asset purchases would reduce the
ratio of federal debt to gross domestic product (GDP) by about 1.5 percentage points by late
2018. The lower debt-to-GDP ratio mainly reflects stronger tax revenue as a result of
morerobust economic activity.
Finally, let me comment on the possibility that our asset purchase program could threaten
financial stability by promoting excessive risk-taking, a significant concern that I and my
colleagues take very seriously. To put this concern in context, though, remember that during
the most intense phase of the financial crisis, risk aversion surged. Even in the aftermath of
the crisis, businesses, banks, and investors have been exceptionally cautious, presumably
reflecting their concern about future business conditions, uncertainty about economic policy,
and the perception of pronounced tail risks relating, for example, to stresses in global
financial markets. I see one purpose of the Committee's accommodative policies as
promoting a return to prudent risk-taking. Indeed, the return to more normal levels of
risktaking and the associated normalization of credit markets have been vital to recovery from
the Great Recession.
Of course, risk-taking can go too far, thereby threatening future economic performance, and
a low interest rate environment has the potential to induce investors to take on too much
leverage and reach too aggressively for yield. At this stage, there are some signs that
investors are reaching for yield, but I do not now see pervasive evidence of trends such as
rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would
clearly threaten financial stability.29 That said, such trends need to be carefully monitored and
addressed, and the Federal Reserve has invested considerable resources to establish new
surveillance programs to assess risks in the financial system. In the aftermath of the crisis,
regulators here and around the world are also implementing a broad range of reforms to
mitigate systemic risk.30 With respect to the large financial institutions that it supervises, the
Federal Reserve is using a variety of supervisory tools to assess their exposure to, and
proper management of, interest rate risk.
To the extent that investors are reaching for yield, I see the low interest rate environment and
not the FOMC's asset purchases, per se, as a contributing factor. It is true that asset
purchases put downward pressure on the term premium component of longer-term rates,
and that discontinuing purchases would likely cause term premiums to rise. But ending asset
purchases before observing a substantial improvement in the labor market might also create
expectations that the amount of accommodation provided would not be sufficient to sustain
the improvement in the economy. This weakening in the economic outlook might bring down
the expected path of the federal funds rate, with the result that longer-term interest rates
might