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

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1 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. 0

2 Three Big Events in Fed History The Great Depression ( ) Inept monetary policy failed to adequately combat credit contraction, deflation, and depression The Great Inflation ( ) 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

3 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

4 Long-Run Strategy for Monetary Policy (January 2012 and January 2013) π * = 2% PCE inflation U t * ~ 5¼% - 6% time-varying SEP long-run sustainable range Balanced approach to reducing deviations of inflation and employment from long-run objectives 3

5 Would Today s Dilemma Be Different under a Single Mandate? Total PCE Price Index (level) Average PCE Inflation ( ): 2.3% Dec % Price-Line from December 2007 Path Implied by Current FOMC Inflation Forecasts '02 '04 '06 '08 '10 '12 '14 '16 Inflation (percent) 3 QE1 QE2 MEP QE3 Total PCE (36-mo. Average) 2 1 Core PCE (12-mo. Change) '02 '04 '06 '08 '10 '12 '14 '16 Source: Inflation forecasts are from the September 18, 2013 FOMC Summary of Economic Projections 4

6 Inflation is Low Globally Consumer Price Index (Q4/Q4 percent change) avg avg. 1.0 Latest Canada Euro zone Japan U.K. 5

7 Balanced Approach to the Dual Mandate Is Consistent with Mainstream Macroeconomics Loss Function (percent) L = (π - π*) (y y*) 2 Inflation L = (π - 2) 2 + (u u n ) 2 π = 5.5% π* FOMC Forecast (September 18, 2013) Current Value u = 9% September 2011 Value u n Unemployment 6

8 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 7

9 Policy Rate Constrained by Zero Lower Bound Fed Funds Rate (percent) 8 6 History 4 2 Q Taylor (1999) Rule based on inflation and output gap '01 '03 '05 '07 '09 '11 '13 8

10 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 π > 2.5% Features of both unconventional tools Lower long-term interest rates Disciplined by economic conditionality 9

11 Asset Purchases: The Fed s Balance Sheet Federal Reserve Assets (Bil. $) 4,000 Nov. 27, ,500 3,000 2,500 2,000 1,500 1, All Other Assets ($305.1 bil.) Agency Debt ($58.4 bil.) Lending and Liquidity Facilities ($2.1 bil.) Treas. Sec ($2,158.5 bil.) Agency MBS ($1,443.7 bil.) 10

12 Forward Guidance on the Federal Funds Rate Zero interest rate at least until U < 6.5% or π > 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 Committee s 2 percent long-run goal, and longer-term inflation expectations continue to be wellanchored. 11

13 Output Gap: 1982 Recovery vs. Today Actual and Potential GDP: 1982 (1981 Q3 = 100) 130 Actual and Potential GDP: 2007 (2007 Q4 = 100) Q '78 '80 '82 '84 ' '05 '07 '09 '11 '13 12

14 Fiscal Policy: Historically Unusual Contributions of Government Purchases to Real GDP Growth (percent) '70 '75 '80 '85 '90 ' '05 '10 13

15 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 14

16 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