Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Brian. By way of background, the Greenbook and many private forecasters project a sizable drop in real GDP from mid-2008 to mid- 2009, followed by sluggish growth into 2010, even with short-term interest rates barely above zero and with substantial fiscal stimulus. The Board staff and the median forecaster in the December Blue Chip survey predict that unemployment will peak around 8.25 percent in 2010. The Greenbook forecast shows core PCE inflation dropping below 1 percent in 2010; many private forecasters envision similar disinflation. Moreover, responses to a special question in the latest Blue Chip survey indicate that private forecasters see a sizable risk of deflation, and stochastic simulations of FRB/US that take the Greenbook forecast as the baseline suggest a roughly 1-in-4 chance that the core PCE price index will decline over one or more of the next five years. In short, forecasts generally suggest that additional stimulus would be desirable.

With the target federal funds rate at 1 percent and the effective rate significantly lower, the Committee has little scope for using conventional monetary policy to stimulate the economy. As a practical matter, the System’s large liquidity-providing operations and the Treasury’s decision to scale back the supplementary financing program make it likely that the effective federal funds rate will remain quite low into the new year. Even so, the Committee could choose to apply some additional stimulus by reducing its target federal funds rate and pushing the effective funds rate closer to zero.

The research literature strongly suggests that a central bank should quickly cut its target rate to zero when it faces a substantial probability that conventional monetary policy will, in a few quarters, be constrained by the zero lower bound on nominal interest rates. But as discussed in several of the notes you received on December 5, driving short-term interest rates to zero would have costs as well as benefits. Zero or near-zero rates cause a high volume of fails in the Treasury securities market, leading to decreased liquidity in that market and potentially in other fixed-income markets. And if short-term rates remain very close to zero, some money market funds probably will close. Such costs may argue against cutting the target funds rate to zero and driving the effective rate closer to zero.

Whether or not the Committee chooses to cut its target rate to zero, policymakers may find it helpful to expand the use of nonstandard monetary tools. In the current environment, using such tools has two potential benefits. First, they may help the Federal Reserve achieve better expected outcomes on both parts of the dual mandate. Second, nonstandard tools could help mitigate the risk of an even more negative outcome. It may prove useful to group nonstandard tools into four broad categories and treat each category in turn.

The first category is simple quantitative easing. This approach uses conventional open market operations such as buying short-term government debt and conducting repurchase agreements to raise excess reserves in the banking system to a level well beyond that required to drive short-term interbank rates to zero. The objective is to spur bank lending by ensuring that banks have ample funding at very low cost. The Japanese experience suggests that greatly expanding excess reserves, per se, has limited success in spurring bank lending, and thus has modest macroeconomic effects, when banks and borrowers have weak balance sheets.

The second category of nonstandard policy tools is targeted open-market purchases of longer-term securities. The objective here would be to reduce term spreads or credit spreads and thus reduce the longer-term interest rates that are relevant for many investment decisions. The Committee could, for example, direct the Desk to buy a large amount of longer-term Treasuries. The Bank of Japan bought sizable quantities of Japanese government bonds; its purchases are thought to have lowered yields. The available evidence for the United States suggests that adding $50 billion of longer-term Treasury securities to the SOMA portfolio (a bit less than 1 percent of publicly held Treasury debt) probably would lower yields on such securities somewhere between 2 and 10 basis points; a substantially bigger purchase could have a disproportionately larger effect as longer-term Treasuries became scarce. Of course, what matters for the macroeconomy is the effect on private agents’ borrowing costs and wealth. Those effects are difficult to predict. Corporate bond yields should decline with Treasury bond yields, though perhaps less if supply effects are the main reason Treasury yields fall. But corporate bond yields could decline more than yields on Treasuries if the Committee’s action reduces investors’ concerns about downside risks and thus reduces credit risk premiums. Such a boost to confidence could also lift stock prices and household wealth. Another possibility is to instruct the Desk to buy a large quantity of GSE debt and mortgage-backed securities to reduce their yields and thus drive down mortgage rates. As Bill noted, markets reacted positively to the November 25 announcement that the Federal Reserve will buy $100 billion of GSE debt and up to $500 billion of agency-backed MBS; yields on 10-year GSE debt and option-adjusted MBS yields fell about 60 basis points that day, and the spread over 10-year Treasury yields narrowed about 40 basis points. Quoted rates on conventional conforming mortgages declined a similar amount in subsequent days. The magnitude of the announcement effect, which is consistent with estimates from the research literature, suggests that additional targeted purchases of agency debt and MBS could provide further macroeconomic stimulus.

The third major category of nonstandard tools encompasses special liquidity and lending facilities. The Board could choose to expand current facilities or create new ones. Special liquidity facilities for banks and other financial firms are intended to help them meet their customers’ needs for credit by providing a reliable source of funding even if the markets in which those lenders usually raise funds are disrupted or if their depositors withdraw funds. Indeed, these facilities seem to be meeting these needs effectively. The Term Auction Facility, or TAF, is one example; the Asset- Backed Commercial Paper Money Market Mutual Fund Lending Facility, or AMLF, is another. Liquidity facilities may also support specific funding markets. The idea is that such markets are more likely to function if borrowers are confident that they will be able to issue and roll over debt and if lenders are assured that they will be able to fund purchases of debt instruments or reduce their holdings of such instruments when necessary. The Commercial Paper Funding Facility, or CPFF, is an example of this sort of program. Although the commercial paper market has not returned to normal, the CPFF has been helpful in supporting overall credit flows and reducing some credit spreads. Direct discount window lending to creditworthy nonfinancial firms is another potential tool for supporting economic activity. The Federal Reserve Act allows such lending, on a secured basis, if the borrower is unable to obtain adequate credit from banking institutions during unusual and exigent circumstances.

Significant further expansion of the System’s lending programs would raise a host of issues. New facilities that lend directly to individuals, partnerships, or corporations would have to meet the requirements in section 13(3) of the Federal Reserve Act. The Reserve Banks would take on more credit risk unless the Treasury or other parties took substantial first-loss positions. Moral hazard would become a larger issue. The resulting increase in reserve balances would further complicate the implementation of monetary policy unless the FOMC were willing to accept a federal funds rate of essentially zero. Developing satisfactory exit strategies would be challenging. And the practical burdens of designing and operating a sizable number of new liquidity facilities would be substantial. Even so, some expansion might prove useful if credit conditions do not improve.

Communication and commitment strategies are the fourth and final category of nonstandard policy tools. In current circumstances, the Committee might use such strategies in an effort to lower market expectations of future short-term interest rates and thus reduce long-term rates, or it might wish to prevent expectations of deflation from taking hold. I will mention three strategies that the Committee might pursue.

First, research suggests that it would be helpful for the Committee to be explicit about its longer-term goals, particularly about its goal for inflation. Foreign experience supports the theoretical prediction that an explicit and credible inflation objective helps anchor longer-run inflation expectations and thus can help prevent a downward drift in expected inflation and an upward drift in real interest rates during a protracted period of high unemployment and slowing inflation. That is, an explicit longer-run inflation target can prevent the public from thinking that the Federal Reserve will allow inflation to remain persistently below rates that the Committee has previously said are desirable. The Committee has discussed the pros and cons of a numerical objective for inflation several times. You may wish to consider whether the significant risk of deflation and the near certainty that the zero lower bound will constrain conventional monetary policy have changed the cost–benefit calculus.

Second, the Committee could announce that it will seek to run a somewhat higher rate of inflation for a number of years than it will seek in the long run. Such a promise, if deemed credible, would stimulate real activity by raising inflation expectations and reducing medium- and long-term real interest rates. Researchers have proposed several approaches for dealing with the zero lower bound that would operate in this fashion, including targeting a slowly rising price level. These approaches would be a significant departure from historical practice, and so their pros and cons would need to be evaluated carefully.

Third, research suggests that it would be helpful for the Committee to provide more-explicit information about its views on the likely future path of the federal funds rate. Suppose, for example, that the Committee concludes that it most likely will need to keep the federal funds rate close to zero for some time to spur an economic recovery and to prevent a persistent decline in inflation. In the current environment, an announcement to that effect might lead market participants to expect the funds rate to remain near zero for a longer time than they now think likely; the announcement might also lead to an increase in expected inflation. Those changes in expectations would lower nominal and real bond yields, providing some stimulus to economic activity. Theory suggests that it would be important to make clear that the Committee’s current view about the likely future path of policy is conditional on current information and the current outlook and to spell out how the actual policy path would depend on a range of possible future outcomes. Communicating this conditionality could be difficult.

The bottom line from the staff’s analysis is that unconventional monetary policy tools can be useful complements to well-designed fiscal stimulus and to steps to recapitalize and strengthen the financial system. Additional purchases of longer-term securities, expansion of targeted lending facilities, and explicit statements of policymakers’ goals and intentions all seem likely to be useful when conventional monetary policy is constrained by the zero lower bound on nominal interest rates. Our limited experience with these tools makes it difficult to estimate the amount of macroeconomic stimulus that would be generated by each and thus makes it difficult to calibrate their application. If the Committee and the Board choose to make greater use of nonstandard tools now or in the near future, it may be appropriate to deal with the uncertainty by using the tools in combination. Finally, the Bank of Japan's experience suggests that nonstandard tools are more likely to be effective if they are used aggressively. I’ll now turn back to Brian.

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