The Fed's reaction to the great recession was "far from perfect," and it should have provided more stimulus, Federal Reserve Bank of New York President and Chief Executive Officer William C. Dudley said Tuesday.
"Comparing actual growth to the growth projections by FOMC participants in the Summary of Economic Projections shows that we were consistently too optimistic about growth over the 2009-2012 period," Dudley told the Japan Society, according to prepared text of his speech, released by the Fed. "As a result, with the benefit of hindsight, we did not provide enough stimulus."
Using lessons from Japan's economic woes in the 1990s, "we might have been more skeptical about the prospects for a strong economic recovery, even with a more aggressive monetary policy regime."
Dudley also said the Fed could have better communicated its "intentions and goals" emphasizing earlier "our commitment to use all our tools to the fullest extent possible for as long as needed to achieve our dual mandate objectives."
Another area where the Fed could have improved, he said, is avoiding the "start-stop" aspect of policies. "For example, until September 2012, our large-scale asset programs generally specified the total size of the program, with a purchase rate and an expected ending date. This created a void when the programs ended and made our policy response sporadic and hard to forecast," he said. "This limited the scope for market prices to adjust in anticipation of our future actions in ways that would help stabilize the economy."
Using date-based forward guidance "was clumsy in a number of respects," Dudley said. "If we moved the forward date guidance out in time, did this reflect a change in our reaction function, the amount of desired policy stimulus or greater pessimism about the outlook?"
However, Dudley said, "we have acted to rectify these shortcomings."
Six lessons can be taken from the crisis and response, including: the importance of managing expectations, the importance of good communication, asset purchases are an effective tool, the sum is greater than its parts, risk management is particularly important, and there are limits to monetary policy.
When managing expectations, it is vital to keep inflation expectations near the Fed's 2% target and to know when the rate target is "zero bound" forward guidance is "the predominant vehicle by which a central bank's actions affect financial market conditions."
Communication must clearly explain "the policy framework, the relationship between the use of tools and the central bank's mandated objectives at the zero bound, and how the use of these tools will evolve with changes in the outlook."
The Fed's credibility is essential to making this work. "Only if a central bank does what it promises to do will expectations be solidly anchored," Dudley said. "Of course, this does not mean mechanically following a set policy trajectory regardless of how the outlook changes, but it does mean that the stance of policy over time must evolve in ways consistent with the criteria established in the guidance. It is important to communicate how policy will respond to changing economic circumstances over time. This is particularly important when the outlook changes, because expectations about how policy will respond can be an important self-stabilizing element of monetary policy. In this regard, a framework that ties the use of policy tools explicitly to economic outcomes has many advantages."
While managing expectation is critical, Dudley said, "I am somewhat skeptical of the view that forward guidance on the policy rate alone is sufficient in these circumstances." Asset purchases are effective.
"Another important insight is that each of the components of policy-the current stance in terms of the policy rate and the balance sheet, expectations about the future stance, the degree of commitment to future policy, and the clarity of communications-all interact," he added. "Our tools are more powerful used in combination, and, when their use is explicitly tied to the outcomes we seek to achieve. As a result, the sum is more powerful than the component parts."
To prevent deflation, risk management is essential. "Policymakers need to put considerable weight on this risk and conduct monetary policy with sufficient aggressiveness to ensure that they avoid such an outcome.
"It is also true that we have less experience with the monetary policy tools used at the zero bound. As a result, there is greater uncertainty around the efficacy and costs of these tools. This pushes in the opposite direction of being more cautious," he said.
The constraints on policy at zero bound, "fall into three broad buckets," Dudley said.
"First, there are costs associated with non-conventional tools. This means they cannot simply be used without limit, though the appropriate limit will vary based on the outlook and balance of risks. The most obvious example of this is our large-scale asset purchase program. As the balance sheet increases in size, the potential costs increase in terms of market functioning, risks to financial stability, and the path of future remittances to the U.S. Treasury.
"Second, there is a limit on how far the expectations channel can be exploited. As I discussed earlier, since the current FOMC cannot bind future FOMCs and the economic outlook is highly uncertain, it isn't reasonable to expect that policies that affect expectations many years in the future will have a powerful impact today. I believe that the effectiveness of the expectations channel decays as the length of the horizon extends.
"Third, monetary policy is only one leg of the stool necessary to generate a vibrant and sustained economic expansion. In particular, as noted earlier, the health of the financial system is critical. For without it, the monetary transmission channels will be impaired and monetary policy will be less effective in influencing the cost and availability of credit. Similarly, it is critical that fiscal policy be set appropriately. This means the short-term impulse needs to be properly calibrated to the current set of economic circumstances (not too much restraint) and the long-run budget trajectory needs to credible and consistent with fiscal sustainability. Finally, removing structural impediments that hinder growth and economic rebalancing are also important. In the case of the U.S., this could include changes in immigration policy, infrastructure investments that remove bottlenecks and job training programs that improve the quality of human capital."
Going forward, Dudley said, the Fed should be ready to alter the asset purchase program up or down based on the labor market and inflation outlooks.
"Because the outlook is uncertain, I cannot be sure which way-up or down-the next change will be. But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook," he said. "At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases. Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment."
Also, he said, exit principle may need to be adjusted to "ensure they do not unnecessarily constrain our ability to conduct policy in the most effective way today. Those exit principles stated that we would first stop reinvesting, then raise short-term interest rates, and finally sell agency mortgage backed securities over a three-to-five year period. This seems stale in several respects. In particular, how does one time the end of reinvestment given that we now have economic thresholds that govern the timing of liftoff? Also, the thresholds are thresholds, not triggers. Thus it is hard to link the timing of the end of reinvestment to the unknown liftoff date for short-term rates."