In a recently released white paper analyzing actions taken by theFederal Reserve in the immediate aftermath of the 2008 financial crisis, St. Louis Fed VP Stephen D. Williamson questions a few of the central bank’s policies and the effect they have had on the economy.
In a section of the white paper titled “Unconventional Monetary Policy After the Great Recession,” Williamson covers three areas which he says comprised a program of “unconventional policy” by the Fed starting in 2009: The zero interest-rate policy (ZIRP); quantitative easing, or large-scale asset purchases; and forward guidance.
Even though the Fed’s ZIRP is nothing new, since the interest rate on reserves during the Great Depression was zero, Williamson points out that it is unprecedented in post-1951 United States. He contends that the ZIRP period constitutes a “liquidity trap” in which reserves and Treasury bills are “essentially equal assets.” Williamson said that the zero interest rates enacted by the Fed in 2008 and are still in place have not had their intended effect on inflation. Instead, he said, “the relevant long-run determinant of inflation, in a nominal-interest-rate-targeting monetary regime, is the level of the nominal interest rate. Indeed, mainstream monetary theory and the experience of Japan for the last 20 years tells us that extended periods of ZIRP lead to low inflation, or even deflation.”
It is possible, Williamson said, for the Fed to become permanently trapped in ZIRP because of the Taylor rule that dictates how much the Fed should raise rates in response to other economic conditions.
“If the playbook for the Fed’s forward guidance in the post-Great Recession period was supposed to have come from received macroeconomic theory, then it seems clear that the FOMC was not following instructions correctly.”
“With the nominal interest rate at zero for a long period of time, inflation is low, and the central banker reasons that maintaining ZIRP will eventually increase the inflation rate,” Williamson wrote. “But this never happens and, as long as the central banker adheres to a sufficiently aggressive Taylor rule, ZIRP will continue forever, and the central bank will fall short of its inflation target indefinitely.”
QE, which consisted of purchases of long-maturity Treasury securities and mortgage-backed securities, has served to increase the Fed’s balance sheet by more than four-fold since before the crisis and substantially increase the average maturity of the Fed’s assets, according to Williamson. But while the Fed’s rationale for QE was articulated by then-chairman Ben Bernanke in 2012, Williamson said that the theory behind QE is “not well-developed.”
“Further there is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed inflation and real economic activity,” Williamson wrote. “Indeed, casual evidence suggests that QE has been ineffective in increasing inflation. For example, in spite of massive central bank asset purchases in the U.S., the Fed is currently falling short of its 2 percent inflation target.”
Forward guidance was an attempt on the part of the Fed to provide more explicit information on policy statements instead of letting the central bank’s actions speak for themselves, according to Williamson. Like the ZIRP, however, Williamson says the Fed’s forward guidance may have had the opposite effect of what was intended.
“If the playbook for the Fed’s forward guidance in the post-Great Recession period was supposed to have come from received macroeconomic theory, then it seems clear that the FOMC was not following instructions correctly,” Williamson wrote. “‘Extended period’ is far too vague to have any meaning for market participants; monetary policy rules should be specified as contingent plans rather actions to take place at calendar dates; ‘thresholds’ are meaningless if nothing happens in response to crossing a threshold. Thus, the Fed’s forward guidance experiments after the Great Recession would seem to have done more to sow confusion than to clarify the Fed’s policy rule.