The research staff at the Federal Reserve (Fed), always active, produced a standout report earlier this year.[i] It amounts to a debriefing on the effectiveness of the extraordinary policy measures taken during the past seven years to deal with first the financial crisis of 2007-08 and then its aftermath. The analysis concludes that the Fed’s special policies, quantitative easing and explicit guidance to the market on interest rate directions, lifted asset prices almost immediately but took an inordinate amount of time to have an impact the economy. Even so, it recommends that the Federal Reserve Open Market Committee (FOMC), the Fed’s policy arm, not alter its approach, that such policies, even unmodified, should have a prompter and more complete economic impact should the Fed have to resort to them in the future.
The Fed first turned to unconventional policies in 2008, as it became clear that the county faced an enormous financial crisis. The Fed’s first, more conventional move was to lower its benchmark federal funds rate, effectively to zero. Following that, policy makers began their new policies. One was a series of quantitative easing programs to channel liquidity directly into the bond markets and so bring longer yields down below where they would otherwise have gone. To get market action to reinforce those direct policy actions, the Fed initiated a second novel approach, the practice of what it describes as “forward-leaning guidance on the future path of the federal funds rate.” By directly pushing down bond yields and telling the market explicitly that it planned to keep rates and yields low for an extended time, policy makers hoped to bring down borrowing costs in every aspect of the U.S. economy and financial markets and so “bolster prices of corporate equities and residential properties,” boost aggregate demand, and check “undesirable disinflationary pressures,” Fed speak for getting the economy moving again.
The research notes the massive scope of the quantitative easing. The Fed’s direct bond buying raised its holdings of treasury, agency, and mortgage-backed bonds from $500 billion before the crisis to $4.0 trillion when the last aspects of the program ended in October 2014. The purchases raised the average maturity of the Fed’s bond portfolio from 1.6 years just prior to the 2008-09 recession to 6.9 years at the end of 2014. The nature of the “forward-leaning guidance” changed over time. It began with general descriptions of how long policy makers planned to hold their accommodative rate policy, then offered specific calendar dates, and then settled on descriptions of the economic conditions that might alter policy. All, however, was more forthcoming than the Fed had ever been in the past.
As with all such studies, the researchers used elaborate models to test how effectively the policies have worked. After all the number crunching, a description of which this discussion will spare the reader, the research effort reached mixed conclusions. Each stage of quantitative easing, it determined, had its greatest impact when it was announced, even before the money flowed. That effect reduced longer yields for a time by some 60 basis points below where they would have settled in the absence of the program. The effect then decayed, the research determined, until the next announcement. Beyond the immediate impact on longer bond yields, the quantitative easing combined with the forward guidance, had a prompt impact on asset prices, first checking the recession-driven declines in equity prices and household wealth and then helping to sustain rallies. The research also notes that the unconventional policies, as well as the decision to hold the federal funds rate near zero, pushed down the foreign exchange value of the dollar. At no point does the study estimate what part of the asset rally or the dollar’s decline was a result of the unconventional policies and what part stemmed from other influences.
The research shows less relative success meeting the policies’ macroeconomic objectives. Policy makers looked for the unconventional efforts to bring the overall unemployment rate down 1.2 percentage points below where it would otherwise settle. That effect waited almost seven hard years, until 2015, to occur. The Fed expected these policies to raise the general rate of inflation in the United States some 0.5 percentage points. This event has yet to happen and will likely wait, these researchers conclude, until 2016. They blame these disappointingly sluggish economic responses on two things: 1) Policies were implemented very gradually, allowing for adjustments that delayed their macroeconomic impact. 2) The financial community had such little confidence in the Fed’s promises to stick to its stimulative course that it refused to act as aggressively or as thoroughly as was needed to have the desired macroeconomic effects.
Despite these failings, the researches recommend little change for Fed policy responses to any future crises. It would seem from their analysis of what went wrong that a more sudden and extreme implementation of quantitative easing and a more explicit use of forward-leaning guidance would help, but the research does not make such a recommendation. Neither does it suggest adding new policies to the mix in order to elicit a more prompt economic response. Rather, it argues the same policy mix will work better in the future because market participants have learned from the recent experience that the Fed means what it says when it tells them that it will remain stimulative and it will, if necessary, push quantitative easing to unprecedented levels. That knowledge, they effectively assure the FOMC, will prompt the aggressive financial response necessary to achieve desired macroeconomic responses.
It is easy to suspect such a conclusion. After all, it argues that despite past failings there is no need for change and would recommend the exact same game plan should another crisis emerge. In the context of the research, their conclusion has a point, but a more proactive approach still would offer more comfort that things in the future would work out better. Let us all hope that circumstances spare markets and the Fed a test any time soon.
[i] Eric M. Engen, Thomas T. Laubach, and David Reifschneider, “The Macroeconomic Effects of the Federal Reserve’s Unconventional Monetary Policies”, Federal Reserve Finance and Economic Discussion Series, 2015-005, January 2015.