Up Front

Monetary Policy in 2011: Unconventional and Necessary

Donald Kohn

In 2011, as in 2010, the Federal Reserve took “unconventional” steps to boost economic growth and speed a very sluggish recovery from the “great recession.” In the early part of the year the labor market seemed to be on an improving trajectory, with some substantial gains in employment in late winter. But by late spring, it was clear that the pace of economic growth had slowed. To some extent, temporary factors were responsible for the disappointing performance—the effects of the earthquake in Japan on auto supply chains and the sharp rise in energy prices, which ate into Americans’ spendable income. But the underlying pace of growth also seemed to be slower than expected and insufficient to reduce a still very elevated unemployment rate. Inflation was high for a time, but was expected to come down as energy and other commodity prices leveled out and then fell and as auto production ramped up, taking pressure off vehicle prices.

In its public pronouncements, the Federal Reserve was very clear that it thought that a variety of policy steps, for example in fiscal and housing policies, would be required to really get the economy moving. But it also saw itself as having scope to do more to help the recovery along, and in August and September it acted. In August the Federal Open Market Committee (FOMC) announced that it expected the federal funds rate to remain at its current extraordinarily low level at least through mid-2013; and in September it announced a “Maturity Extension Program” for its portfolio of Treasury securities whereby it would sell shorter-term securities and use the proceeds to buy longer-term securities.

Both of these actions helped to lower longer-term interest rates: The communication about rates by reducing market participants’ views about the likely path of interest rates, or at a minimum lowering the odds on any tightening before mid-2013; the maturity extension (popularly known as Twist) by taking longer-term securities off the market, reducing the rates on these securities, and inducing their former holders to buy other long-term securities thereby spreading the fall in rates through the markets. Lower rates should boost spending by reducing the cost of borrowing to finance purchases, by bolstering the prices of equity and other assets so people are wealthier, and by reducing the foreign exchange value of the dollar making U.S. exports more competitive in global markets.

The actions were controversial. Three members of the FOMC dissented; they felt the steps were unnecessary, ineffective, and potentially counterproductive in that they would ultimately produce higher inflation. Those concerns were also prominent in political discourse; the Federal Reserve has been attacked quite vociferously by Republican candidates for president and the Republican congressional leadership took the unprecedented step of writing to the FOMC just before its September meeting urging it not to engage in the maturity extensions. Those dissents and “advice” clearly did not deter the FOMC, but they did keep it in the spotlight. At the same time, many economists and other commentators, focused on promoting a faster recovery, were making suggestions for monetary policy frameworks and intermediate targets that would encourage even easier policy for longer and loosen constraints from temporarily higher inflation. The sharp contrast in the policy positions being advocated highlights the difficulty of the policy choices and the challenges in explaining those choices to the public.

As 2011 draws to a close, the economy has shown some encouraging signs of slightly stronger growth, despite the bad news from the Euro area and the financial market volatility and risk aversion the problems there have imparted to global financial markets. Still, the obstacles to good growth remain considerable; in addition to European problems and continuing fiscal policy disarray here at home, the housing market remains in the doldrums and income growth for most households has been very weak. At the same time, inflation continues to abate. Thus before long the Federal Reserve could well be facing the same question it grappled with last summer: Is there anything it can do to help the recovery without endangering long-term price stability?

It’s clear from the speeches of FOMC members and the minutes of FOMC meetings that a number of approaches are under consideration, falling into the two buckets we sampled last summer-communication to change expectations and portfolio adjustments to directly lower long-term rates. On the communication side, the FOMC seems to be contemplating being even more explicit about its expectations for the path of interest rates, making a more definitive commitment to an inflation target, and providing a fuller (and I’m sure it hopes more readily understood and accepted) explication of how its policy choices should help the country reach the Federal Reserve’s dual objectives of stable prices and high employment. With respect to its portfolio, various FOMC members have raised the possibility of resuming purchases of mortgage-backed securities, hoping to help the housing market by reducing mortgage rates.

Meanwhile the Federal Reserve must prepare for the potential of even greater disruption from the problems in Europe. This fall it agreed with other major central banks to reduce the interest rate on the dollars it swaps with them. These swaps make dollars available to be lent out by foreign central banks to banks in their home countries or currency areas. European banks have faced mounting difficulties funding themselves in a variety of markets. The ECB has acted to make euros more readily available to them; the Federal Reserve’s action should help the ECB supply dollars as well to slow the deleveraging process and associated tightening of credit conditions in Europe.

Stronger growth in the U.S. and more settled conditions in Europe would enable the Federal Reserve to begin to contemplate unwinding its unconventional polices and dimming the intense spotlight on its actions. Unfortunately, as 2011 draws to a close, that doesn’t seem yet to be in the cards.