S.F. Fed report assesses unconventional monetary policy

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Forward guidance and quantitative easing became important tools for the Federal Reserve in the Great Recession, but received mixed reviews as to their effectiveness.

With interest rates remaining lower than traditional levels, such unconventional monetary policy may be needed again in the future.

“These tools likely strengthened the economic recovery and helped return inflation to the Fed’s target — although their full impact remains uncertain,” writes Glenn D. Rudebusch, senior policy advisor and executive vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco, in an Economic Letter.

Although the Fed slashed the funds rate by more than 5 percentage points during the financial crisis and the Great Recession, the economy needed more stimulus. “With the unemployment rate reaching 10% in 2009, the simple policy rule would have prescribed much more monetary policy stimulus — indeed, an additional 7 percentage points of interest rate cuts,” Rudebusch writes. But with an effective lower bound rate of zero, the funds rate couldn’t be lowered any more.

The Fed turned to “providing forward guidance about future short-term interest rates,” to “push down expectations of future short rates, lower longer-term yields, and ease financial conditions.” Since the Fed did not agree with the expectations of investors for “a quick policy rate liftoff,” Rudebusch said, it offered “explicit forward guidance” including language in the Federal Open Market Committee (FOMC) statement in early January, that it expected “exceptionally low levels for the federal funds rate at least through late 2014.”

The Fed also released the Summary of Economic Projections, including the “dot plot,” that conveyed the message that rates would be at zero lower bound for years.

“During the past decade, forward guidance has generally been viewed as an effective policy tool to support the economic recovery,” he noted. “This is consistent with past episodes when the Fed also employed forward guidance although in a much more circumspect fashion.”

However, there are costs to forward guidance, “and while it can be an important policy tool, the extent of its future use by the Fed is open to debate.”

Quantitative easing, or QE, involved Fed purchases of longer-term bonds. “Much evidence regarding the effects of QE comes from event studies that examine how asset prices shift in the hours after a Fed QE announcement,” Rudebusch notes.

But, he writes, evaluating the immediate reaction of the markets is “not a good measure of the effects of QE if they are reversed in a few days or weeks, and the possibility of such reversals is one reason why the economic impact of QE is still debated.”

On one side, critics claim “QE had a very small and erratic effect on financial conditions and the economy,” while advocates say “the Fed’s total QE program was roughly equivalent to a cut in the federal funds rate of several percentage points.”

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