Outside the box: Unconventional monetary policy in the Great Recession and beyond

Federal Reserve Board Chairman Ben Bernanke (5th R) chairs a meeting of the Federal Open Market Committee, the Federal Reserve's interest rate-setting body, in Washington in this March 17, 2009 picture released on March 19, 2009. The Federal Reserve on Wednesday announced the purchase of longer-dated Treasury securities to help end a deepening U.S. recession. REUTERS/Joe Pavel/Federal Reserve Board/Handout (UNITED STATES POLITICS BUSINESS) FOR EDITORIAL USE ONLY. NOT FOR SALE FOR MARKETING OR ADVERTISING CAMPAIGNS - WASE53J19O901
Editor's note:

This paper was presented at the event, “Unconventional monetary policy: How well did it work?” on October 17, 2018.

After cutting interest rates nearly to zero in late 2008, the Federal Reserve turned to novel and untested monetary policies in an effort to stimulate the economy. In a new Hutchins Center Working paper, a version of which is forthcoming in the Journal of Economic Perspectives, Kenneth Kuttner of Williams College takes stock of what researchers have learned about the Fed’s unconventional monetary policies in the decade since their inception. He highlights outstanding questions about the impact of quantitative easing (QE) and forward guidance measures, and argues that both deserve to remain in the Fed’s recession-fighting toolkit.

Researchers face a number of challenges in measuring the effects of quantitative easing and forward guidance, both because the policies varied in their timing and size and because constructing counterfactual outcomes of the financial crisis is difficult. As a result, research tends to focus on changes in yields on Treasury bonds and mortgage-backed securities, using high frequency data around policy announcements (“event studies”) or time-series analyses of investor preferences (term structure models). While both methods have limitations, Kuttner argues term structure models are better equipped to disentangle the effects of QE and forward guidance, and to measure their cumulative effects on interest rates.

Despite these challenges, a large body of research indicates quantitative easing and forward guidance succeeded in lowering long-term interest rates and supporting economic activity. Several studies show the Fed’s forward guidance lowered expected future short-term interest rates and stabilized medium-term rates even as the economy improved. Estimates from both event studies and term-structure models suggest successive rounds of QE reduced 10-year Treasury yields by about 1½ percent—an effect Kuttner estimates to be comparable to that of a 4½ percentage-point cut in the Federal funds rate.

Still, Kuttner says a number of questions remain unanswered about unconventional policies’ effects.

First, while QE’s significant impact on interest rates is well established, its ultimate effects on economic activity are less certain. Existing studies do suggest, however, that bond yield reductions from QE boosted bank lending, business investment, and GDP growth.

Second, researchers continue to question the extent to which QE worked by reducing supply in segmented asset markets (the “portfolio rebalancing” channel), or by providing an additional signal to markets that the Fed was likely to keep short term interest rates low for some time (the “signaling” channel). Kuttner concludes the research favors the primacy of portfolio rebalancing, suggesting the Fed may be able to achieve some of the benefits of QE without significantly expanding its balance sheet in the future.

Forward guidance and quantitative easing will be essential tools for the Fed in future recessions, but policymakers should consider strategies to make the policies more measurable and effective. Kuttner proposes the Fed should deploy QE and forward guidance in a rule-like manner that clearly relates its actions to its dual mandate and economic forecasts. In addition, the apparent importance of portfolio rebalancing in the transmission of QE has implications for the design of asset purchases and the Fed’s communication about how they will be conducted. Finally, policymakers should treat forward guidance and QE as complementary tools rather than substitutes, as research suggests they operate through different channels but work together to reinforce the central bank’s commitment to monetary expansion.

Read the full paper here.

*Sage Belz and David Wessel contributed to this post. 

A version of this paper will be published in the Fall 2018 issue of the Journal of Economic Perspectives, Volume 32, Number 4. 

The author did not receive financial support from any firm or person with a financial or political interest in this article. He is not currently an officer, director, or board member of any organization with an interest in this article.