U.S. Monetary Policy Since Late 2007

1. U.S. Monetary Policy Since Late 2007 Winthrop P. Hambley Senior Adviser April 15, 2014

2. Structure of the Federal Reserve System Board of Governors, Washington D.C. • 7 members nominated by the President, confirmed by the U.S. Senate • Chair (Janet Yellen) and Vice Chair are separately nominated by the President from among Board members, separately confirmed by the Senate. 12 Federal Reserve Banks, each with its own President • each Reserve Bank has a nine member board of directors • of these nine, the six chosen to represent the public nominate the President of their bank (Dodd-Frank Act, 2010) • the Board of Governors approves or disapproves these nominations Federal Open Market Committee • Board members and Reserve Bank Presidents

3. Federal Open Market Committee (FOMC) • key monetary-policy making body of FRS • all 7 Board members, all 12 Bank Presidents participate in FOMC discussions of monetary policy • all Board members and 5 Bank Presidents (NY Fed President always, other Presidents in rotation) vote at FOMC meetings • Reserve Bank Presidents’ role in monetary policy promotes the Fed’s monetary policy independence; their selection process is sometimes controversial • FOMC meets at least 8 times a year in Washington, D.C. • FOMC sets target level for federal funds rate — key monetary policy rate, traditional monetary policy tool. In recent years, FOMC also undertook nontraditional monetary policy, using three additional tools-- large scale asset purchases, enhanced communications with the public about likely future policy (“forward guidance”), and changes in the maturity composition of Federal Reserve’s asset holdings. Governor Duke, “Come with Me to the FOMC,” 10/19/10, describes an FOMC meeting

4. Monetary Policy Mandate • The Federal Reserve is independent—operationally independent--but is not free to do whatever it wants in monetary policy. Instead, “constrained discretion.” • Monetary policy reflects legal mandate established by Congress • Since 1977, goals of monetary policy have been established by law: monetary policy is to promote “maximum employment, stable prices, and moderate long term interest rates.” These goals, equal in statute, are not defined in the law. • These goals now called the “dual mandate”: Fed is to promote (1) maximum employment and (2) stable prices. (If both attained simultaneously, “moderate long term interest rates” would be achieved automatically—real long-term interest rates consistent with full employment, no premium in nominal interest rates for expected future inflation). • Most FOMC participants currently believe that the “mandate consistent” measure of “maximum employment” is an unemployment rate in the range of 5.2% to 6%. They view an inflation rate of 2% per year, measured by the PCE index, as consistent with their price stability and maximum employment mandates. • At times, the two goals in the “dual mandate” may temporarily conflict, requiring tradeoffs. • In the long run, maximum sustainable employment is best achieved by attaining and maintaining price stability. The two goals are ultimately complementary. (See former Chairman Bernanke, “The Benefits of Price Stability,” 2/06)

5. Monetary Policy Mandate Chair Janet Yellen on the dual mandate: “I strongly support both parts of the Federal Reserve’s dual mandate: price stability and maximum employment. I have led the committee to produce a statement concerning its (the FOMC’s—ed.) longer-run policy strategies and goals that puts both of these on an equal footing.” “I strongly support the Federal Reserve’s dual mandate, both parts of it. Both price stability and employment matter enormously to American households. I think the dual mandate serves this country well. And there is no conflict, most of the time and especially now, between pursing both pieces of this.” “I am committed to achieving both parts of our dual mandate—helping the economy return to full employment and returning inflation to 2 percent, while ensuring that it does not run persistently above or below that level.” -- Yellen testimony at House Committee on Financial Services, 2/11/14

6. Monetary Policy Transparency monetary policy transparency: • decision on funds rate target and other policy actions announced immediately after FOMC meetings, with brief explanation, in FOMC statement/press release. This includes votes by name for or against the policy action; since 12/08 has included “forward guidance” on likely future policy re: funds rate and/or asset purchases (see the latest FOMC release, below) • minutes of each FOMC meeting released after three weeks (unique among central banks) • edited transcripts of FOMC meetings, and all meeting materials, released after five years (unique among central banks) • Chair’s two (effectively, four) regular semiannual monetary policy testimonies, accompanied by formal monetary policy reports, and numerous other Congressional testimonies by Chair and Board members • Since April, 2011, Chair has given quarterly monetary policy press briefings after FOMC meetings (video available on Board’s web site); coincident release of Survey of Economic Projections by FOMC participants (SEP) • weekly H.4.1 release shows effects of monetary policy on Fed’s assets, liabilities and balance sheet (Fed is the only central bank that publishes its balance sheet) • new explicit 2% PCE inflation goal, and disclosed range of estimated “longer-run normal rate of unemployment” associated with “maximum employment” (range currently 5.2% to 6%) clarify Fed’s understanding of its dual mandate and promote accountability. First stated in FOMC principles, 1/25/12; reaffirmed 1/29/13 and 1/28/14. The Federal Reserve is the most transparent central bank in the world.

7. Open Market Operations:Achieving the Funds Rate Target Open market operations (OMO): Fed purchases, or sells, government securities in the market. OMO are usually a means to an end--achieving a targeted level of the federal funds rate. • banks and other depository institutions (DIs) have accounts at their bank, the Fed • at any given time, some DIs have more balances in their accounts than they want or need for transactions, or to meet reserve requirements, and supply funds in the “federal funds” market; others have fewer balances than they want or need, and demand funds in that market • the federal funds rate is the short term (overnight) interest rate DIs charge (or pay) one another to lend (borrow) these balances; it equates the supply of, and demand for, balances in the federal funds market • normally, the Fed can control the federal funds rate quite closely—can keep it quite close to the target for the funds rate established by the FOMC--through open market operations • if the federal funds rate is above the FOMC’s target, the Fed buys government securities from banks (or from primary dealers), and pays by adding to amounts in DIs’ (or primary dealers’ banks’) accounts at the Fed; this increases the supply of federal funds relative to the demand, reducing the funds rate • if the funds rate is below its target, the Fed sells government securities, taking payment from buying DIs’ accounts, reducing the supply of federal funds, and raising the funds rate • in normal times, if OMO are properly calibrated, the supply of federal funds will equal the demand at the targeted level of the federal funds rate

8. How Traditional Monetary Policy Works • ordinarily, reductions in the federal funds rate provide financial stimulus, increase household and business spending, and increase “aggregate demand” (Increases do the opposite.) How? • monetary policy works, in part, by influencing longer-term interest rates; Fed influences,but does not “set,” longer-term interest rates • the interest rate on a longer term loan is an average of two things, the current short term rate and the average short term rate currently expected over the term of the loan, plus an additional amount (premium) that compensates the lender for the pure interest rate risk of holding a longer-maturity asset and any credit risk of lending to a particular borrower rather than the Treasury. (expectations /term premium theory of term structure of interest rates) • traditional monetary policy—the funds rate target, open market operations to achieve the target, and how the Fed talks about its policy and the economy--affects both current short term rates and the expected average of future short term rates, thus affecting two of the three determinants of longer term rates. • A lower funds rate tends to lower other short term interest rates. If also accompanied by a lower expected average of future short term interest rates--as is usually the case--this would also lower longer-term rates. (A higher funds rate accompanied by higher expected future short term rates, in contrast, would raise long term rates.)

9. How Traditional Monetary Policy Works (cont.) • recent research also suggests that traditional monetary policy also affects the premium(s) in longer-term rates that compensate the lender for interest rate risk and any credit risk. A reduction in the funds rate target, and the funds rate, compresses the premium(s), thereby lowering longer-term rates. (Stein speech 2/21/14) (An increase in the target and actual rate, in contrast, lifts longer-term rates.) Thus, monetary policy influences all three of the determinants of longer-term interest rates. • these effects on longer-term interest rates stimulate borrowing and spending by households and businesses when longer-term rates fall, and restrain spending when longer-term rates rise. • monetary policy is only one influence—although an important one-- on interest rates and on spending decisions. Many things other than monetary policy (e.g., changing lender perceptions of credit risk and of the risk of future inflation, the stance of fiscal policy, and the stage of business cycle, international capital flows…) also affect interest rates, and many factors other than interest rates (e.g. consumers’ wealth, current income, and confidenceabout the future; the availability of credit for consumer and business spending; government fiscal policies, economic conditions abroad...) affect spending.

10. How Traditional Monetary Policy Works (end) Traditional policy also affects spending indirectly by affecting asset prices and wealth, and exchange rates: • Monetary policy affects asset prices, including stock prices and house prices, and thus affects household wealth, an important determinant of consumer spending. For example, a reduction in interest rates will reduce discount rates used to evaluate expected future dividends on stocks, and thus will generally be associated with higher stock prices, greater wealth, and increased consumption spending. And if lower long-term interest rates increase borrowing to buy houses, and thereby increase the demand for housing, house prices will also be higher, also increasing wealth and consumption spending. Stock prices are also an important influence on investment spending by businesses; higher stock prices will tend to increase such spending. • Monetary policy also affects exchange rates which, in turn, affect U.S. and foreign demand for U.S.- made goods and services. For example, if monetary policy results in lower U.S. interest rates (with foreign interest rates unchanged), the U.S. will be a relatively less attractive place in which to invest. Foreigners wanting to make fewer financial investments in the U.S. will decrease their demand for dollars, which will decrease the price of the dollar in foreign exchange markets. A less expensive U.S. dollar will reduce the price of U.S. goods to foreigners in their own currencies, which will tend to spur foreign demand for U.S. goods. Also, the lower price of the dollar will make it relatively more expensive in dollars for Americans to buy foreign goods, and Americans will switch some of their purchases from now more-expensive imports to now relatively less-expensive U.S. goods and services. Both of these “switching effects“ increase the demand for U.S. produced goods and services, and so increase aggregate demand in the U.S.

11. Monetary Policy Influences Aggregate Demand The key in monetary policy is to use the federal funds rate (or other policy tools) to try to influence longer-term interest rates and, thus, overall spending decisions, and thereby align “aggregate demand” with “potential output”—the output the economy could produce if employment was at its maximum sustainable level (or, equivalently, if the unemployment rate was at its lowest sustainable level). (Potential output is not known with certainty, but can be estimated.) “Potential output” changes over time, and usually grows, so this would involve not only trying to align aggregate demand with (estimated) potential output, but also keeping aggregate demand aligned with—and growing with-- this usually growing “moving target.” The Fed wants to keep demand tracking potential output in a particular way over time: not growing too slowly relative to potential output, which would cause excess supply, making inflation slow or prices fall; and not growing faster than potential output, which would cause demand to outstrip potential output, resulting in excess demand and inflation. It is seeking “price stability”-- prices that are “stable,” not rising very much on average, over time. If the Fed does these things, it will achieve both of the goals in its dual mandate.

12. Difficulties in Monetary Policy • monetary policy does not work immediately. It works with a lag, so • policy cannot be solely based on data (which reflect the recent past, not the future, and, in any case, are often revised), but must also be informed by forecasts • even if policy has intended effect on interest rates and spending—lowering interest rates (and increasing asset prices and lowering exchange rates) to increase the growth of aggregate demand/spending in the current context-- other factors affecting spending may comprise “headwinds” that work against that effect, tending to slow the growth of aggregate demand. • monetary policy has had to contend with shifting “headwinds” ever since the recovery began in mid-2009. Hence, the relatively slow growth of aggregate demand, despite aggressive policy easing. • the current headwinds may gradually be abating; if so, the growth of demand will increase and the recovery will strengthen. (see section on current “headwinds,” below)

13. Responding to Shocks to Aggregate Demand • If a shock occurs that depresses aggregate demand below what is necessary to purchase potential output, causing unemployment to rise—as happened in the 2007-2009 Great Recession--monetary policy can respond by acting to lower longer-term interest rates, in order to stimulate spending, and to arrest and limit the decline in demand. • Monetary policy then can help demand to begin increasing, and then increasing faster than the growth of potential output. In that way, monetary policy can help make demand and actual output “catch up” to potential output, closing the “GDP gap” and lowering the unemployment rate to a rate consistent with maximum employment. • The U.S. economy and monetary policy have been in this phase of demand expansion since the current recovery began in June 2009. • Stimulating the growth of demand in this way can also help to prevent an unwanted decline in the rate of inflation below the targeted 2% rate that defines price stability. • At some point, as the economy recovers, and demand and actual output approach potential output, monetary policy will have to change and provide less stimulus to aggregate demand. The purpose of doing this would then be to slow the growth of demand and actual output to the growth of potential output, so as to avoid overshooting potential output and causing excess demand and inflation. • While “exiting” from accommodative policy, interest rates ultimately will have to rise to more normal levels, in order to slow the growth of aggregate demand to the growth of potential output. • The “exit” phase of current monetary policy has not yet begun, and is still sometime in the future.

14. Recent Monetary Policy End of the Housing Boom and the Situation in the Summer of 2007 By the summer of 2007, the housing boom had ended. After a long period of rising housing demand, ever-faster house price increases, and expanding homebuilding, housing demand had stopped growing. House prices had peaked sometime in 2006, ending expected future houseprice appreciation. (chart, house price index) At that point, homes had simply become too expensive for people to continue to buy, and to borrow to pay for. With the end of expected future house price appreciation, investors’ speculative demand for housing—including newly produced housing--abruptly shrank. In response, home sales and residential investment spending declined (and later fell much further). Home-building and construction-related employment contracted. Thus, initially, residential construction and employment in homebuilding were a weak spot in the real economy, otherwise strong and close to full employment. With an excess supply of housing, and a large and growing inventory of unsold houses, house prices started falling. In the latter part of the housing boom, hybrid 2/28 and 3/27 mortgages had become common. These loans had a fixed rate for the first two or three years. After those “introductory” periods, their interest rates adjusted upward significantly, and, for the remaining 28 or 27 years varied with movements in an index. This design strongly “encouraged” borrowers to refinance before rates reset in order to avoid the higher rates.

15. Recent Monetary Policy Because credit had been easily available, and home prices had been increasing, borrowers had thought they could easily refinance existing loans, using the equity that they expected would have built up in their home through rising house prices. Or, if necessary, they could sell their homes for more than they had borrowed to repay their mortgage debts. Borrowsers expected mortgage credit to continue to be readily available and expected to have built home equity through price appreciation. (Lenders, expecting continued house price appreciation, agreed.) But many of these borrowers had put little or nothing “down” when they borrowed. And when house prices stopped rising, they were no longer building equity in their homes “automatically.” Many other borrowers had taken out “option ARM” mortgage loans, which allowed them to pay only interest--or even less than interest--each month. Having made only such small payments initially, they had not paid down any principal on their mortgages—they had built little or no home equity through their monthly mortgage payments. Still other homeowners had taken out and spent any equity they had, by using “cash out” refinancing, or by drawing on home equity loans or home equity lines of credit. As a result, many borrowers had little or no--or even negative--home equity.

16. Recent Monetary Policy (cont) After a long period of good loan performance, helped by rising house prices and a strong economy, lenders had begun to experience unexpectedly high losses on poorly underwritten, now hard-to-refinance home loans, many of such poor quality that borrowers defaulted very early in the term of the loans, and many others of which had suddenly become more expensive to borrowers on a “monthly payment” basis, due to interest rate resets or adjustments. (At first, this rise in delinquencies showed up in subprime ARMs, later in other ARMs, later, with recession, in fixed rate loans). (chart, delinquency rates) Rising mortgage delinquencies and defaults resulted in increased home foreclosures (chart) that added to the excess supply of houses and thus, to downward pressure on house prices. For the many borrowers with little or no equity in their homes, a drop in house prices meant negative equity--owing more on their homes than the homes were worth. This gave such borrowers—even those who could make payments—an incentive not to repay their mortgages, further increasing delinquencies and defaults. (This incentive later magnified by a very large--one-third--cumulative decline in house prices.) The later recession, with higher unemployment and lower incomes, further reduced borrowers’ ability to repay home loans. Deteriorating mortgage performance and falling prices on homes securing home loans caused unexpected losses for lenders, losses for investors on mortgage-backed securities (MBS) and mortgage-related securities like CDOs, and losses for insurers of mortgages and mortgage-related securities. The ultimate size and incidence of these losses across institutions and investors was unclear, creating a fertile ground for the later financial panic.

17. Recent Monetary Policy (cont) With rising mortgage losses, demand for MBS and CDOs, and their prices, declined, causing additional mark-to-market losses for financial institutions and investors that held them. In response, lenders began to tighten the terms and availability of new mortgage credit, and then of other forms of credit, from 2007 on, slowsing aggregate demand growth. In 2007, as investors shunned private label MBS, securitization of subprime mortgages collapsed; later, in late 2008, “structured finance “ in general contracted sharply, making credit for many types of spending –student loans, small business loans, etc.-- less available and more expensive. Securitization suddenly became a far smaller source of credit supporting spending, which had a significant negative impact on aggregate demand. All this was already underway in summer 2007, with the economy near full employment. Policy aimed to prevent a further drop in aggregate demand, which would aggravate underlying problems. If demand dropped, it would increase unemployment and lower incomes, reducing borrowers’ ability to repay all types of loans, further increasing mortgage (and other) loan losses, further increasing foreclosures and excess housing supply, further reducing home prices and depressing MBS and CDO values more, further damaging financial institutions, causing them to tighten credit even more, further reducing demand… By bolstering aggregate demand, policy aimed to forestall “negative feedback loops” between the housing and mortgage markets, the financial system, and the macro-economy.

18. Recent Monetary Policy (cont) Monetary Policy Responds From September of 2007 until mid-2009, because of demand shocks, the U.S. economy was weakening relative to its potential. This happened slowly at first, then much more dramatically after mid-2008 and into early 2009. (chart, GDP gap) A recession, now called “the Great Recession” because of its length and depth, began in December of 2007 . (Shaded area in chart denotes the recession). From late 2007 until the middle of 2008, the U.S. economy was growing (aggregate demand and actual output were increasing), but more slowly than estimated potential output. A modest “gap” opened up between actual output and estimated potential output, with actual output below potential. Coincident with the intensification of the financial crisis from 9/08 into early 2009 (“the Great Panic”), aggregate demand and output began to fall in the third quarter of 2008, then fell more rapidly in Q4 of 2008 and Q1of 2009. Sharply falling stock and house prices cut wealth and aggregate demand. Three key components of U.S. aggregate demand--consumption, investment, and net export spending--all fell. A concomitant recession and financial panic in Europe and elsewhere intensified these effects. The U.S. economy stopped declining in Q2 of 2009. By then, a big difference--or gap-- had developed between the “potential output” the economy could produce at full employment, and the lower amount it was actually producing. With a delay, the unemployment rate increased from 4.4% (its low) in May 2007, slowly at first, then faster after mid-2008, until reaching a peak of 10% in October 2009. (chart, “unemployment rate”)

19. Recent Monetary Policy (cont) During this entire period, and continuing to the present, the Fed has aggressively sought to boost the growth of aggregate demand through traditional monetary policy. (chart, “federal funds rate target”) In order to counter actual and expected macroeconomic weakness, starting in September of 2007 and continuing until December of 2008, the Fed rapidly reduced its target for the federal funds rate from 5-1/4% to an “exceptionally low” range of 0% to ¼% (nearly 100%). That exceptionally low range for the funds rate remains in place today. Starting in December 2008, deeply worried about the overall economy, the Fed aggressively used two nontraditional tools, large scale asset purchases and forward guidance—communications about the likely future path of the federal funds rate and other policy measures-- to further lower longer-term interest rates and provide more stimulus to demand. Although aggregate demand did fall at first, and monetary policy, working with a lag, did not avert a severe recession, aggressive policy easing prevented aggregate demand from being lower, unemployment from being higher, and the housing and mortgage markets and the financial system, from being in far worse condition at each later point in time.

20. Recent Monetary Policy (cont) Initially, the ultra-low federal funds rate, two early versions of forward guidance aiming to lower long term interest rates, and the initiation of a first round of large scale asset purchases (see below) to lower term premiums and further lower long term rates— helped stopped an ongoing decline in aggregate demand by mid-2009. Consequently, a much more serious recession—perhaps a second Great Depression and deflation (prices falling persistencly on average)--was avoided. Other governmental policies--including liquidity programs established by the Fed and related actions by the Treasury, the Federal Deposit Insurance Corporation and Congress that prevented a collapse in the financial system, and the incoming Obama Administration’s 2009 fiscal stimulus program--also helped. In mid-2009, in part because of aggressive monetary policy easing, aggregate demand and output stopped falling, stabilized, began rising, and then began to grow more rapidly than potential output. The recession ended in mid-2009, and the economy began to recover. Demand growth accelerated in the second half of 2009, and the economy registered 3.1% growth in real GDP in 2010. Expansionary monetary policy supported an earlier, stronger recovery than would have otherwise occurred.

21. Recent Monetary Policy (cont) Later in the recovery, at times when demand growth faltered or was too slow to promote timely attainment of the dual mandate, the Fed undertook: • repeated efforts to strengthen forward guidance about the likely future path of the federal funds rate and other policy measures in order to further lower longer term interest rates (see below on “forward guidance”); • an explicit policy to maintain the size of the Fed’s balance sheet, whose purpose was to avoid a passive tightening of policy that would otherwise have resulted from the normal runoff of maturing assets; • a second round of large scale asset purchases (see below); • a “maturity extension” program that aimed at further lowering term premiums and longer-term interest rates (see below) • and a third, open-ended, round of large scale purchases of mortgage backed securities and Treasury securities that is still ongoing, albeit at a pace that was reduced in December 2013, again in January 2014, and again in February 2014. All of these “nontraditional” policies were undertaken in order to prod demand and output to keep growing fast enough to outpace the growth of potential output, and thus to reduce the “GDP gap” and lower the unemployment rate to a rate consistent with “maximum employment.” At times, additional stimulus was also needed to prevent an unwanted decline in inflation.

22. Recent Monetary Policy (cont) • Policy today is highly accommodative, and appropriately so. The funds rate is essentially zero, cannot go lower, and has been “exceptionally low” for more than five years. • Aggressive “forward guidance” currently suggests that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal…” Also, “Even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer-run.” • The Fed’s balance sheet has grown sharply, now exceeds $4 trillion in assets, and is still growing rapidly. Two earlier rounds of large scale asset purchases greatly enlarged the Fed’s balance sheet; the third, ongoing round of asset purchases is currently adding $55 billion in additional assets each month. • The Fed turned virtually all of its short term Treasury assets into longer term assets via “maturity extension.” • All this easing is cumulative—one stimulus policy on top of another. Nonetheless, the recovery has been slow and modest because policy has been, and still is, pushing against strong “headwinds” which have tended to slow the growth of aggregate demand.

23. Recent Monetary Policy (end) • The unemployment rate, currently at 6.7% (March 2013), remains well above the 5.2% to 6% range of unemployment rates the FOMC believes is consistent with “maximum employment.” It is expected to gradually decline. Inflation measured by the PCE index is currently a bit below 1% per year, a figure well below the FOMC’s 2% inflation target. Inflation is expected to rise gradually over time, but still to remain below 2%, for the next several years.

24. Monetary Policy Balances Benefits and Costs Potential Benefits of Policy Easing through low funds rate, LSAPs, MEP, Forward Guidance: Downward pressure on longer-term interest rates: • fosters stronger recovery, increasing employment and output and promotes attainment of “maximum employment” • maintains inflation closer to the FOMC’s 2% target • guards against downside risks to the economy But potential benefits must be weighed and reassessed continually against potential costs. Potential Costs of Policy Easing through Lower Longer-Term Rates: • could increase expectations of future inflation, and increase actual future inflation • could impair market functioning in Treasury or MBS markets • enlarged balance sheet could potentially complicate policy normalization and exit strategy • could adversely affect financial stability, by inducing investors and financial institutions to “reach for yield” imprudently--that is, increase their risk-taking in order to raise expected returns on investments. Balance between potential benefits and costs may change over time.

25. Large Scale Asset Purchases Starting in late 2008, the Federal Reserve has engaged in three rounds of “large scale asset purchases” (“LSAPs”): • From December 2008 until March of 2010, the Fed bought $1.7 trillion worth of three types of assets: mortgage backed securities (MBS) guaranteed by Fannie Mae and Freddie Mac, debt issued by these government sponsored entities (GSEs), and Treasury securities. (First round of LSAPs was dubbed “quantitative easing” by the press—”QE” for short.) • In November 2010, the Fed announced a second round of large scale asset purchases, this time $600 billion worth of longer-term Treasury securities; it ended in June 2011 (“QE 2” ) • Through the first two rounds of LSAPs, in 2½ years, the Fed added $2.3 trillion to its asset holdings, and tripled in asset size. • Starting in September 2012, the Fed began to buy $40 billion per month in MBS guaranteed by Fannie and Freddie. The total amount to be bought was open-ended, with no preannounced total amount of purchases. In December 2012, the Fed also began to buy longer-term Treasury securities at a rate of $45 billion per month; again, the amount to be bought was open-ended. (“QE 3”). These amounts were each reduced by $5 billion per month starting in January of 2014, and each by a further $5 billion per month In February 2014 and again in March 2014. But the Fed is still adding assets rapidly--$55 bilion/month

26. How LSAPs Work and How Much • Large scale asset purchases work through a “portfolio balance channel” to lower term premiums and longer-term interest rates. Bernanke 8/31/12: “different classes of assets are not perfect substitutes in investors’ portfolios… Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields should decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.” (Bernanke, 11/20/12: same results if buying Treasuries.) • research shows Fed’s purchases of MBS, GSE debt, and Treasury debt have had the intended effect of (reducing term premiums, thereby) lowering longer term interest rates, including mortgage interest rates. Such effects have buoyed aggregate demand. • Bernanke, 8/31/12: “studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. …the first (LSAP) program, in particular, has been linked to substantial reductions in MBS yields and retail mortgage rates. “

27. How LSAPs Work and How Much(cont.) • Bernanke 8/31/12: “The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points.” • Bernanke, 8/31/12, “Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases (including the MEP) found total effects between 80 and 120 basis points on the 10-year Treasury yield.” • LSAP effects on stock prices and wealth likely also helped to buoy demand. Bernanke, 8/31/12: “LSAPs also appear to have boosted stock prices, presumably both by lowering discount rates and by improving the economic outlook; it is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases. The effect is potentially important because stock values affect both consumption and investment decisions.” • Bernanke, 8/31/12: “model simulations conducted at the Board find that securities purchase programs have provided significant help for the economy.” A simulation using the FRB/US model of the U.S economy found that “as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.” • Bernanke, 8/31/12: “evidence shows that “securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks.”

28. How LSAPs Work and How Much (end) • In summary: “For the most part, research supports the conclusion that the combination of forward guidance and large-scale asset purchases has helped promote the recovery. For example, changes in guidance appear to shift interest rate expectations, and the preponderance of studies show that asset purchases push down longer-term interest rates and boost asset prices. These changes in financial conditions in turn appear to have provided material support to the economy.” (then-Chairman Bernanke 1/3/14) • Chair Janet Yellen: “I think that quantitative easing, or purchases of securities, did serve to push down mortgage rates, and other longer-term interest rates quite substantially…” (testimony at House Committee on Financial Services, 2/11/14)

29. Potential Costs of Large Scale Asset Purchases Then-Chairman Bernanke has previously noted that LSAPs (and accommodative policies generally) have potential costs, while noting that those costs have not yet materialized: • potential disruption of securities markets by LSAPs—but “to this point we have seen few if any problems in the markets for Treasury or agency securities.” (8/31/12) • further expansion of the Fed’s balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time—but“the expansion of the balance sheet to date has not materially influenced inflation expectations, likely in part because of the great emphasis the Federal Reserve has placed on developing tools to ensure that we can normalize monetary policy when appropriate.” (8/31/12) • LSAPs, and prolonged low longer-term interest rates, potentially create risks to financial stability. By driving long term yields lower, policy could induce an imprudent “reach for yield” by some investors who take on more credit risk, duration risk, or leverage, thereby threatening financial stability—but”little evidence thus far of unsafe buildups of risk or leverage.”(8/31/12) Bottom line: “To this point we do not see the potential costs of the increased risk-taking… as outweighing the benefits.” (2/26/13). At the same time, “the Federal Reserve is working to address financial stability concerns through increased monitoring, a more systemic approach to supervising financial firms, and reform to make the financial system more resilient.” (5/22/13)

30. Potential Costs of Large Scale Asset Purchases (end) • The Federal Reserve could incur financial losses due to a rise in interest rates--but “Extensive analyses suggest that…the odds are strong that the Fed’s asset purchases will make money for the taxpayers, reducing the federal deficit and debt. And, of course, to the extent that monetary policy helps strengthen the economy and raise incomes, the benefits for the U.S. fiscal position would be substantial.” (8/31/12) Like former Chairman Bernanke, new Fed Chair Yellen views the potential of current monetary policy to create future financial instability as the most serious potential risk. As she stated in testimony at the House Financial Services Committee on February 11, 2014: “We recognize that in an environment of low interest rates like we’ve had in the United States now for quite some time, there may be an incentive to reach for yield, and that we do have the potential to develop asset bubbles or a buildup of leverage or rapid credit growth or other threats to financial stability. So especially given that our monetary policy is so accommodative, we’re highly focused on trying to identify those threats. … Broadly speaking, we haven’t seen leverage, credit growth, (or) asset prices build to the point where generally I would say that they were at worrisome levels. …looking at a range of traditional valuation measures doesn’t suggest that asset prices, broadly speaking, are in bubble territory or outside of normal historical ranges.”

31. Maturity Extension Program • Beginning in August, 2011, and continuing until June 2012, the Federal Reserve sold $400 billion of shorter-term Treasury securities and used the proceeds to buy an equivalent amount of longer-term Treasury securities. This increased the average remaining term to maturity of the Federal Reserve’s Treasury securities holdings. This was the Fed’s “maturity extension program,” MEP. • In June 2012, the FOMC extended the MEP until the end of 2012, selling an additional $267 billion in shorter-term Treasury securities and buying more longer-term Treasury securities. • By reducing the average maturity of securities held by the public, the MEP “puts additional downward pressure on longer-term interest rates and further eases overall financial conditions.”(Bernanke 9/4/12). More formally, the MEP took “duration” and interest rate risk out of the market, making the public willing to hold remaining longer term Treasuries at a higher price and lower yield; spillover effects lowered other interest rates. MEP was done to further lower longer term interest rate and further increase aggregate demand. • MEP did not change the size of the Federal Reserve’s balance sheet. While the composition of its assets shifted toward longer maturities, total assets remained the same. Since, on net, no new assets were bought, no net additional balances were credited to depository institutions either, so the Fed’s total liabilities also remained unchanged. MEP was additional stimulus without increasing the size of the Federal Reserve’s balance.

32. Forward Guidance Currently, there are two categories of “forward guidance”—(1) guidance on the likely future path of the federal funds rate and (2) guidance on the likely future course of asset purchases: 1. Forward Guidance on the Federal Funds Rate: Since late 2008, the FOMC has used “forward guidance” about the likely future of the range for the federal funds rate to encourage the public to believe that the Fed would keep the federal funds rate very low for longer than previously expected. In its press releases, the FOMC stated, successively, that it expected the federal funds rate would remain “exceptionally low”: • “for some time” (starting in the December 2008 FOMC release) • “for an extended period” (starting in March 2009) • “at least until mid-2013” (starting in August 2011) • “at least until late 2014” (starting in January 2012) • “at least until mid-2015” (starting in September 2012, continued until December 2012). Such communications lowered the expected future path of the funds rate and of other short term rates, and so tended to lower longer term rates (which, recall, are averages of current short term rates and expected future short term rates, plus an additional amount or “term premium”).

33. Forward Guidance December 2012 Changes to Forward Guidance on the Funds Rate: “State Contingent Guidance” In December 2012, the FOMC abandoned date-based communications (such as “at least until mid-2015”) about the anticipated future path of the range of the federal funds rate. In a major change, the FOMC then tied the funds rate range to quantitative economic conditions, stating that the Committee then anticipated that its exceptionally low target range for the federal funds rate of 0- ¼ percent “will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well-anchored.” (emphasis added). This guidance remained in subsequent FOMC releases until it was dropped in March 2014. This quantitative guidance provided information about the objective circumstances under which policy—as reflected in the federal funds rate-- could begin to be tightened. But, as Chairman Bernanke then stressed, this statement did not put monetary policy on autopilot. For example, it did not mean that the funds rate target would automatically be increased when the unemployment rate reached 6.5%, only that the FOMC wouldn’t consider raising it before then.

34. Forward Guidance December 2013--FOMC changes and strengthens forward guidance on the funds rate: In December 2013, because of substantial cumulative improvement in labor market conditions and in the labor market outlook, the FOMC decided to begin slowing down the monthly pace of its third round of asset purchases, then $85 billion per month, in anticipation of gradually ending purchases. It coupled this decision with stronger forward guidance on the funds rate. After repeating that the FOMC continued to expect that the “exceptionally low’ range of the federal funds rate would remain appropriate at least as long as the unemployment rate exceeded 6 -1/2 percent,“ etc. (italics added), the Committee added the following strengthening statement: “The Committee now anticipates …that it will likely be appropriate to maintain the current target range for the federal funds rate well past the time that unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” (italics added) These two paragraphs remained the guidance until March 2014, when the FOMC dropped them.

35. Forward Guidance March 2014 : New (and current) qualitative guidance on the funds rate By the March 2014 FOMC meeting, the unemployment rate had declined and was close to the 6.5% threshold that the FOMC had said earlier could trigger consideration of starting to increase the federal funds rate. But much of the improvement in the unemployment rate had been due to a decline in the labor force participation rate, so the value of the unemployment rate as a threshold, and as a summary statement of the health of the labor market, had diminished. The significance of 6.5% had also been diminished by the FOMC’s earlier promise to keep the funds rate exceptionally low “well past the time” that 6.5% was passed. Moreover, the FOMC felt that the market wanted more information on the likely timing of funds rate increase, stated in a way that retained the FOMC’s ability to respond flexibly to incoming information in the future. These considerations, and a desire to reassure market participants that the Fed was not planning to raise interest rates any time soon (because the FOMC felt the recovery was still far from complete) led to the FOMC’s new forward guidance, which links the timing of any future increase in the funds rate to realized and expected progress in achieving the dual mandate, and the end of the third round of asset purchases:

36. Forward Guidance “In determining how long to maintain the current 0 to ¼ percent target range for the federal funds rate, the Committee will assess progress—both realized and expected—toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range of the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer term inflation expectations remain well anchored. “When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with it longer run goals of maximum employment and inflation of 2 percent.” The FOMC then added this reassurance regarding the level of future rates: “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run” (e.g. below 4% )

37. Forward Guidance 2. Forward Guidance on Asset Purchases In September 2012, the FOMC announced a new third, open-ended, round of large scale asset purchases, specifically, purchases of agency mortgage backed securities, MBS. Initially, $40 billion of MBS would be purchased each month. This announcement was accompanied by a statement setting out qualitative criteria concerning how long the FOMC would continue these MBS purchases. These criteria initially said that asset purchases would continue until there was a substantial improvement in the outlook for the labor market (italics added) “achieved in a context of price stability”. Thus, the initial version of this guidance in the September 2012 FOMC release stated; “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

38. Forward Guidance In December 2012, the FOMC announced it would begin purchasing longer-term Treasury securities, initially at a rate of $45 billion per month. (These purchases replaced the purchases of longer-term Treasuries under the MEP, which was ending, and would be in addition to the ongoing MBS purchases.) The FOMC then repeated its earlier qualitative guidance for asset purchases (after broadening it to include purchases of both Treasury securities and MBS), again stating that “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability.” This guidance on asset purchases later evolved into the following form, which still tied the end of the Fed’s asset purchases to achieving a substantial improvement in the outlook for the labor market, and also to price stability. As the FOMC stated, starting in September, 2013, “The Committee….will continue its purchases of Treasury and agency mortgage backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.” (emphasis added) This statement remains in the most recent FOMC releases.

39. Forward Guidance The FOMC explained how it will decide when to start tapering its asset purchases in the release following its September and October 2013 meetings: “In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases.” At its December 2013 meeting, the FOMC began to reduce the pace of its asset purchases from $85 billion per month to $75 billion per month. That decision reflected a judgment that by then there had finally been both substantial cumulative progress in actual labor market conditions and a substantial improvement in the outlook for the labor market.

40. Forward Guidance In December 2013, when announcing its decision to reduce the monthly rate of its asset purchases by $10 billion, the FOMC added the following statement about the likely future course of asset purchases: “If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer–run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation, as well as its assessment of the likely efficacy and costs of such purchases.” In January 2014 and again in March 2014, the FOMC reduced the monthly pace of its asset purchases by a further $10 billion, each time repeating the statement in the preceding paragraph. Going forward, if developments continue to show ongoing improvement in the labor market outlook and inflation rising toward 2%, the FOMC will likely continue to taper purchases at future meetings. But changes in that outlook, and in assessments of the efficacy and costs of purchases, could alter the expected taper path.

41. Current Forward Guidance In sum, under current guidance about the funds rate target and asset purchases, the FOMC believes the sequence of future monetary policy changes will likely be: • first, if conditions suggest an ongoing improvement in the outlook for the labor market, and inflation moving back to the FOMC’s 2% target, as expected, “the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings” • second, ultimately, the FOMC will end new asset purchases; the stock of Fed assets will peak • third, the FOMC will likely then allow a “considerable period” to pass. (Chair Yellen recently suggested this period might be about six months.) During this time, in line with current policy, the Fed would maintain the size of its balance sheet by reinvesting proceeds of any securities that mature in new securities. This would maintain downward pressure on interest rates. • fourth, after that period ends, the FOMC could begin to raise the target for the funds rate, based on an assessment of progress—both realized and expected –toward the objectives of maximum employment and 2 percent inflation. • fifth, “When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

42. Current Forward Guidance • Finally, the FOMC currently believes that “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

43. The Timing of “Tapering” At his press conference on June 19, 2013 , Chairman Bernanke said the Federal Reserve might start to reduce its then-current round of large scale asset purchases “later this year,” and end them “around the middle of 2014,” provided the economy followed the path of moderate recovery then forecast by the Fed. He stated: “If the incoming data are broadly consistent with this forecast, the (Federal Open Market) Committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year. If the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.” Thus, LSAPs would end mid-2014. This possible timeline for tapering, and then ending, asset purchases, was dependent on the Fed’s forecasts, and on the evolution of the economy over time being ”broadly aligned” with the Fed’s expectations. The actual timeline for first tapering, and later ending, asset purchases was always (and still is) data dependent—it depended on the state of the economy in the future, as reflected in data then available, and how it compared to forecasted outcomes.

44. The Timing of “Tapering” • At its September and October 2013 meetings, the FOMC delayed the start of tapering based on the judgment that the test of “substantial improvement in the outlook for the labor market” had not yet been met. • In December 2013, incoming data finally seemed to suggest both substantial cumulative improvement in labor market conditions and a “substantial improvement in the outlook for the labor market,” and the FOMC decided to begin to taper its asset purchases starting in January 2014. • In January 2014, making similar judgments, the FOMC decided to taper further, starting in February. • In March 2014, making similar judgments, the FOMC decided to taper further, starting in April.

45. Credit Easing and the Fed’s Balance Sheet Since mid-July of 2007 (just before the onset of the financial crisis) the size of the Federal Reserve’s balance sheet has increased dramatically. (H.4.1 releases, 7/19/07, 4/10/14): • The Federal Reserve’s assets have more than quadrupled from $876 billion to $4.24 trillion • composition and average maturity of Fed assets has changed dramatically since mid-2007: • U.S. government securities holdings increased from $790 billion to $2.33 trillion; • holdings of Fannie Mae- and Freddie Mac-guaranteed MBS—not previously held-- have risen sharply, and now total $1.6 trillion. In addition, average maturity of Federal Reserve’s securities holdings has increased via long-term asset purchases and maturity extension. • FR liabilities have also increased sharply. Deposits of depository institutions at Reserve Banks (which are liabilities of the Federal Reserve) have increased from $20 billion to $2.70 trillion. Nearly all of this is excess reserves – amounts above those necessary to meet reserve requirements. (Currency outstanding, Fed’s other main liability, now $1.23 trillion.) • The huge amount of excess reserves, if lent, could support inappropriately low future interest rates, and a substantial future increase in bank lending and aggregate demand. Currently, overall bank lending is increasing slowly, so this is only a potential future risk. Ultimately, though, as aggregate demand and credit demand strengthen and the economy recovers, these excess reserves will need to be drained or neutralized, the balance sheet shrunk, communications changed, and interest rates nudged higher, or “normalized,” to avoid excessive stimulus to aggregate demand that could cause future inflation.

46. Will Monetary Policy Increase Future Inflation? Chairman Bernanke: 10/1/12: “The Fed’s price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that’s about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. “For controlling inflation, the key question is whether the Federal Reserve has the policy tools to tighten monetary conditions at the right time so as to prevent the emergence of inflationary pressures down the road. I’m confident that we have the necessary tools to withdraw policy accommodation when needed… “Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to “take away the punch bowl” is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools.”

47. FOMC Release 3/19/14 “Information received since the Federal Open Market Committee met in January indicates that growth in economic activity slowed during the winter months, in part reflecting adverse weather conditions. Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated. Household spending and business fixed investment continued to advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable. “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those that the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

48. FOMC Release 3/19/14 (cont.) “The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in the labor market. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in its pace of asset purchases. Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee’s sizeable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.

49. FOMC Release 3/19/14 (cont.) “The Committee will closely monitor incoming information on economic and financial developments in coming months, and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.

50. FOMC release 3/19/14 (cont.) “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to ¼ percent target range for the Federal funds rate, the Committee will assess progress—both realized and expected—toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided longer-term inflation expectations remain well anchored. “When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the long run.