Monetary Policy: Lessons from the Past and Looking Forward to the Future

The Federal Reserve at 100 Loyola University Chicago December 6, 2013 Charles L. Evans President and CEO Federal Reserve Bank of Chicago
The views I express here are my own and do not necessarily reflect the views of the Federal Reserve Bank of Chicago, my colleagues on the Federal Open Market Committee (FOMC) or within the Federal Reserve System.

Three Big Events in Fed History

The Great Depression (1929-1938)

Inept monetary policy failed to adequately combat credit contraction, deflation, and depression
The Great Inflation (1965-1980)

Monetary policy failed to recognize structural changes and expectational dynamics that led to double-digit inflation
The Treasury Accord (1951)

An example highlighting the importance of central bank independence

1

Academic Foundations of Modern Central Banking

Great Depression: Central banks must address nominal crises

Friedman and Schwartz (1963) Bernanke (1983, 1985)

Great Inflation: Central banks must distinguish real

from nominal cycles Friedman (1968) Lucas (1972) Kydland and Prescott (1982)

Central bank independence: Central banks must be able to

act as necessary Kydland and Prescott (1977) Barro and Gordon (1983) Rogoff (1985)
2

Long-Run Strategy for Monetary Policy

(January 2012 and January 2013)
* = 2% PCE inflation Ut* ~ 5% - 6%

time-varying

SEP long-run sustainable range

Balanced approach to reducing deviations of inflation

and employment from long-run objectives

Would Todays Dilemma Be Different under a Single Mandate?

Total PCE Price Index
(level) 120 Dec. 2007
2% Price-Line from December 2007 Average PCE Inflation (2000-2007): 2.3% Path Implied by Current FOMC Inflation Forecasts

110
100 90 80 2000

'02

'04

'06

'08

'10

'12

'14

'16

Inflation
(percent) 3
Total PCE (36-mo. Average)

QE1

QE2 MEP QE3

1
Core PCE (12-mo. Change)

0 2000

'02

'04

'06

'08

'10

'12

'14

'16

Source: Inflation forecasts are from the September 18, 2013 FOMC Summary of Economic Projections 4

Inflation is Low Globally

Consumer Price Index
(Q4/Q4 percent change) 4.0

3.0
2000-2007 avg. 2012

2.0

2008-2011 avg.

Latest

1.0

0.0

-1.0 Canada Euro zone 5 Japan U.K.

Balanced Approach to the Dual Mandate Is Consistent with Mainstream Macroeconomics

Loss Function
(percent)

L = ( - *)2 + 0.25 (y y*)2 L = ( - 2)2 + (u un)2

Inflation

= 5.5%

2015 2016 2014

u = 9%
September 2011 Value

FOMC Forecast (September 18, 2013)

Current Value

un
6

Unemployment

Why Has Achieving Dual Mandate Been So Hard?

Deleveraging in the aftermath of the financial crisis

Global risks

Unusually restrictive fiscal policy

Monetary policy constrained by zero lower bound

Policy Rate Constrained by Zero Lower Bound

Fed Funds Rate
(percent) 8

History
4

2 Q3-2013 0

-2

Taylor (1999) Rule based on inflation and output gap

-4

-6 1999 '01 '03 '05 8 '07 '09 '11 '13

Policy Tools at the Zero Lower Bound

Large Scale Asset Purchases $45 bil. in Treasuries & $40 bil. in agency MBS per month

until substantial improvement in labor market outlook

Forward Guidance Zero interest rate at least until U < 6.5% or > 2.5% Features of both unconventional tools Lower long-term interest rates Disciplined by economic conditionality

Asset Purchases: The Feds Balance Sheet

Federal Reserve Assets
(Bil. $) 4,000 Nov. 27, 2013 3,500 3,000

2,500
2,000 1,500 1,000 500 0 2007

2008

2009

2010

2011

2012

2013

All Other Assets ($305.1 bil.) Agency Debt ($58.4 bil.) Lending and Liquidity Facilities ($2.1 bil.) 10

Treas. Sec ($2,158.5 bil.) Agency MBS ($1,443.7 bil.)

Forward Guidance on the Federal Funds Rate

Zero interest rate at least until U < 6.5% or > 2.5% Thresholds December 2012: Economic conditions likely to warrant

exceptionally low level of the funds rate 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 of a

percentage point above the Committees 2 percent long-run goal,

and longer-term inflation expectations continue to be wellanchored.

11

Output Gap: 1982 Recovery vs. Today

Actual and Potential GDP: 1982
(1981 Q3 = 100) 130

Actual and Potential GDP: 2007

(2007 Q4 = 100) 130

115

115

100

100

Q3-2013

85

85

70 1976

'78

'80

'82

'84

'86 12

70 2003

'05

'07

'09

'11

'13

Fiscal Policy: Historically Unusual

Contributions of Government Purchases to Real GDP Growth
(percent) 3

-1 1965

'70

'75

'80

'85 13

'90

'95

2000

'05

'10

Looking Ahead: Exit Principles (June 2011 Minutes)

Balance sheet size

Smallest level consistent with efficient monetary

policy operation
Balance sheet composition

Treasury only
Likely normalization sequence

Taper, then end LSAPs

Cease reinvestment of maturing securities

Begin raising rates and drain reserves
New tools: IOER, RRP Facility, term deposits
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Looking Ahead to the Future

Balanced approach to deviations from goals

Inflation preferences should be symmetric

Must recognize limitations of monetary policy during

episodes in which real cycles dominate

15