At the Annual Dinner of the National Economists Club, Federal Reserve chairman Ben Bernanke gave a speech that walked through the reasoning for all of the Fed’s big actions since the financial crisis.
He explained why the Fed has used unconventional monetary policy in the aftermath of the Great Recession. The ultimate goals of these policies has been to shape the public’s policy expectations to convince it that it would keep policy loose for an extended period of time.
Here are the key themes he talked about:
Bernanke emphasised the importance of clearly articulating the future of Fed policy using forward guidance. This was particularly true after the great recession when the Fed’s usual policy tool, short-term interest rates, had limited effectiveness due to the zero-lower bound. The FOMC attempted to lower long-term rates by communicating to the market that short-term rates would be low for a long period of time. This was the goal of forward guidance.
At first, the Fed did this in a qualitative sense, but eventually started using more date-specific guidance to communicate to the market. However, this guidance also had its own limitation:
Although the date-based forward guidance appears to have affected the public’s expectations as desired, it did not explain how future policy would be affected by changes in the economic outlook–an important limitation. Indeed, the date in the guidance was pushed out twice in 2012–first to late 2014 and then to mid-2015–leaving the public unsure about whether and under what circumstances further changes to the guidance might occur.
To offset this, the Fed recently moved to a more state-contingent guidance, noting that the Fed would not consider raising rates while unemployment was above 6.5% and inflation was near 2%. Bernanke emphasised these were thresholds, not triggers, meaning that hitting the targets would not automatically cause rate increases but were a necessary level for rates to rise.
Large Scale Asset Purchases (LSAPs)
The Fed also implemented a new, unconventional monetary policy tool that had the same goal of lowering long-term rates, but did so in a different manner. Instead of credibly informing the market that short-term rates would be low for a longer period of time, LSAPs reduced long-term rates by purchasing securities. This reduces the supply and drives up the value of them, lowering rates. Bernanke lays this dual strategy of forward guidance and LSAPs clearly in his speech:
[F]orward rate guidance affects longer-term interest rates primarily by influencing investors’ expectations of future short-term interest rates. LSAPs, in contrast, most directly affect term premiums… As both forward rate guidance and LSAPs affect longer-term interest rates, the use of these tools allows monetary policy to be effective even when short-term interest rates are close to zero
The FOMC also has attempted to credibly communicate to the market “the criteria that would inform future decisions about the program.” The goal of this was to keep market expectations in line with the Fed’s future plan of actions. To do this, Bernanke laid out the baseline state of the economy at which the Fed would begin to reduce its asset purchases. In June, the chairman said that if the market continued to improve at a moderate pace as it had been, then it would begin tapering later in the year and conclude its asset purchases in mid-2014.
Bernanke emphasised that this was not a pre-determined plan, but was data-dependent. The market didn’t listen:
Market participants may have taken the communication in June as indicating a general lessening of the Committee’s commitment to maintain a highly accommodative stance of policy in pursuit of its objectives. In particular, it appeared that the FOMC’s forward guidance for the federal funds rate had become less effective after June, with market participants pulling forward the time at which they expected the Committee to start raising rates, in a manner inconsistent with the guidance
The market priced in a September taper, despite the fact that it would depend on how the economic data would unfold in the ensuing months. This was not what the Fed intended to communicate in June and caused tightened financial conditions in the housing market. When the data came in below the baseline level that Bernanke laid out in June, the Fed did not reduce its asset purchases. As Bernanke says, this was “fully consistent with the earlier guidance.”
Since then, market expectations have realigned with the Fed with the market more focused on the data and applying the Fed’s framework to it to predict future Fed policy:
Although the FOMC’s decision came as a surprise to some market participants, it appears to have strengthened the credibility of the Committee’s forward rate guidance; in particular, following the decision, longer-term rates fell and expectations of short-term rates derived from financial market prices showed, and continue to show, a pattern more consistent with the guidance.
This speech succinctly summed up all of the Fed’s actions under Bernanke. It used forward guidance and LSAPs to attempt to lower long-term rates, because short-term rates were pushed up against the zero lower bound. It has become more transparent and attempted to clearly communicate the framework for its future policy decisions to credibly convince the market that policy will remain loose for a considerable period of time.
As Bernanke said at the beginning of his speech, “the public’s expectations about future monetary policy actions matter today because those expectations have important effects on current financial conditions, which in turn affect output, employment, and inflation over time.” This has been the ultimate goal of his time as chairman.
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