NEW YORK – The extraordinary measures taken by the Fed, since the Fed funds rate target was near zero, were “useful,” Federal Reserve Bank of San Francisco President and CEO John C. Williams said Friday.
Williams said he expects “an extended period of policy challenges,” in the U.S. and “developments in monetary economics will be crucial to the future success of monetary policy.”
“The evidence from the experiences of the past few years convincingly demonstrates that both forward guidance and large scale asset purchases are useful policy tools when short-term interest rates are constrained by the zero bound,” Williams told the Swiss National Bank Research Conference, according to prepared text of his speech, which was released by the Fed.
He estimated that LSAPs moved yields 15 to 20 basis points, which he said is the same effect as a 75-basis point cut in the Fed funds rate target.
Williams discussed forward policy guidance and large-scale asset purchases. Forward policy guidance, in theory, “is a potentially powerful tool that can almost completely solve a central bank’s problems at the zero lower bound,” he said. But, there are reasons to be skeptical it would work in practice: “One of these caveats is implicit in the theory itself. The optimal forward guidance policy is not time-consistent. According to the theory, for this policy to have the desired effects, the central bank must commit to two things: keeping the short-term policy rate lower than it otherwise would in the future, and allowing inflation to rise higher than it otherwise would. However, when the time comes for the central bank to fulfill this commitment, it may not want to do so,” choosing to raise rates in order to avoid higher inflation.
A second problem is the expectations of the future course of the economy and monetary policy may be different for central bankers and the public. “The expectations channel is crucial for the effectiveness of optimal forward guidance policy,” he said. Without a perfect “understanding of the central bank’s intended policy path,” forward guidance could fail. And optimal forward guidance “depends on myriad factors and risk assessments … difficult to convey to the public.”
But forward guidance worked, he said. Studies concluded “the Federal Reserve’s policy statements have significant effects on financial market expectations of future policy actions and on Treasury yields.”
When the Fed announced in August that it would keep rates exceptionally low through mid-2013, Williams said, “two-year Treasury yields fell by about 10 basis points and ten-year Treasury yields fell by about 20 basis points following the announcement. This provides prima facie evidence of the powerful effects of forward guidance at the zero bound.”
Large-scale asset purchases work through several channels, but Williams highlighted two: signaling and portfolio. “The signaling channel works through the effects asset purchases have on public expectations of future short-term interest rates. The portfolio channel works through the effects on factors that affect yields other than expectations of future short-term interest rates.”
When a central bank buy assets, it signals “its strong intention to add monetary stimulus by other means as well,” he said. “Such signaling may lower longer-term yields in two ways. First, it could lower the expected future path of short-term rates. Second, it could reduce the uncertainty around this path, which may reduce the interest rate risk associated with holding longer-term securities.”
The portfolio channel deals with the size and composition of the central bank’s balance sheet.
Williams suggested studying four questions: What are the effects of LSAPs on the overall economy?; What approach should central banks take in formulating and communicating unconventional policies, whether forward guidance or LSAP programs?; Should unconventional policies be a regular part of our toolkit or should they be reserved only for extraordinary times? and how do these policies change our thinking about the optimal rate of inflation?
“These questions offer a wealth of important topics for researchers to explore,” he said. “The lessons we learn from this research will be critically important when central bankers consider unconventional policies in the future.”
