We use cookies on our website to give you the best online experience. Please know that if you continue to browse on our site, you agree to this use. You can always block or disable cookies using your browser settings. To find out more, please review our privacy policy.

About


Policy Hub: Macroblog provides concise commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues for a broad audience.

Authors for Policy Hub: Macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

Comment Standards:
Comments are moderated and will not appear until the moderator has approved them.

Please submit appropriate comments. Inappropriate comments include content that is abusive, harassing, or threatening; obscene, vulgar, or profane; an attack of a personal nature; or overtly political.

In addition, no off-topic remarks or spam is permitted.

October 18, 2021

Market Response to Taper Talk

As the Fed discusses reducing its $120 billion in monthly purchases of Treasury and mortgage-backed securities, market pundits have begun to form opinions on whether such talk about tapering will roil markets as it did in 2013. Some believe that, given the size of the Fed's monthly purchases, such discussion will lead to similar market reactions. Others believe that markets today better understand the Fed's decision-making process around its asset purchases and interest rate policy. This market knowledge and experience may help mitigate the negative effect taper talk could have this time. In this post, we provide evidence that both perspectives are at least partially correct.

To be specific, we analyze the past and present discussions on tapering, including the effects that the Federal Open Market Committee's (FOMC) September 2013 meeting, often referred to as the "untaper" meeting because plans for tapering were delayed, and the June 2021 "talking about talking about tapering" meeting had on the market's expectations for the future path of the fed funds rate. We show that a market response similar to 2013 has already occurred in the sense that an increase in the 10-year Treasury rate coincided with market participants expecting an earlier liftoff from a fed funds rate of zero. Subsequent taper talk only marginally affected how the market expects the pace of rate hikes to proceed. In other words, the market responds to increasing Treasury rates by first pricing in a strong opinion about how much time will pass before the first rate hike. Subsequent discussions about tapering have little to no effect on the market expectations for future interest rate policy.

For our analysis, we use the Federal Reserve Bank of Atlanta's, Market Probability Tracker (MPT), to measure the market's expectations for the future course of monetary policy. The MPT is computed and reported every day on the Federal Reserve Bank of Atlanta's website and is described in detail in an Atlanta Fed "Notes from the Vault" post. The MPT uses options contracts on Eurodollar futures to estimate the market's assessment of the target ranges of future effective fed funds rate. Using derivative contracts on Eurodollars has one main advantage over studying the effective fed fund futures directly. Unlike the futures market for fed funds, the options on Eurodollar futures market is one of the most liquid in the world, with a wide collection of traded options. Moreover, Eurodollar futures deliver three-month LIBOR (or London Interbank Offered Rate), which bears a stable relation and high correlation with the effective fed funds rate in global overnight money markets. Together, these features allow the MPT to extract more confidently measures of market expectations of future effective fed funds target ranges.

Turning our attention first to 2013, we look at how the market's expectations for the future path of rates changed as taper talk began to heat up. In figure 1, we plot several of the MPT's daily expected fed funds rate paths from before and after June 2013. Each unlabeled path in the figure is represented by a transparent blue line of the market expectations for the fed funds rate path as of Wednesday of that week. These weekly expected rate paths began on May 1, 2013, and ended on December 18, 2013, when the Fed announced it would begin paring down its asset purchases.

Figure 1: Market Expectations for the Fed Funds Rate Path

Note: Expectations computed daily with option data on Eurodollar futures contracts from May 1, 2013, to December 18, 2013. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the indicated week.

The orange line in figure 1 represents the market expectations as of May 1, 2013. At that time, no substantive discussion about the Fed shrinking its asset purchases had taken place. The FOMC had just released a statement that it would continue to purchase assets "until the outlook for the labor market has improved substantially in a context of price stability." Regarding its interest rate policy, the Committee stated that it "expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens." Given the Fed's policy, along with the state of the economy, the market expected the first rate hike to be in mid- to late 2015.

Between May 2013 and the next FOMC meeting on June 19, 2013 (the dashed blue line in figure 1), the market's expectation for future monetary policy began to price in an earlier rate hike sometime between late 2014 to early 2015 (see the sequence of transparent blue lines in figure 1 that move up and to the left from the orange to the dashed blue line). During this period between FOMC meetings, Ben Bernanke, then chairman of the Board of Governors, testified to Congress that the FOMC "could in the next few meetings...take a step down in our pace of purchases" (Bernanke Q&A congressional testimony, May 22, 2013).

Bernanke's May 2013 testimony may have contributed to pulling forward market expectations for when the Fed would end its highly accommodative monetary policy since many expected the Fed's asset purchases to end before the fed funds rate was increased from its zero lower bound. The chair's testimony is also credited with setting off what is commonly referred to as the "taper tantrum" in the Treasury market. In figure 2, the blue line shows how much the 10-year Treasury rate had changed since May 1, 2013. According to this figure, Bernanke's testimony was certainly followed by an increase in the 10-year Treasury rate, but this increase continued a trend that began back in May 2013. And market participants had been pricing in an earlier and earlier liftoff date while the 10-year rate was increasing in May, not when the chair testified to Congress.

Figure 2: Change in the Daily 10-Year US Treasury Rate

Note: The blue line represents the change from May 1, 2013, to February 24, 2015. The orange line represents the change from November 5, 2020, to August 27, 2021.

The Committee's June 2013 statement on monetary policy changed little from its May statement, but the expected path for the fed funds rate had already steepened (compare the dashed blue line with the orange line in figure 1). Notably, it was over the six days that followed the June FOMC statement that the 10-year Treasury increased by 40 basis points (see the blue line in figure 2). Many believe this increase in the 10-year rate was due to Bernanke's comments during the post-FOMC press conference when, in responding to a question about asset purchases, he said it would be appropriate to moderate purchases "later this year" and to end purchases "around midyear" 2014. However, for our purposes, we point out the muted impact Bernanke's answer had on the expected rate paths plotted in figure 1.

Over the next couple of months, changes in the fed funds rate path continued to be minimal even in response to Bernanke's attempt to calm other markets by assuring market participants the Fed was committed to a highly accommodative monetary policy. By the September FOMC meeting—a meeting sometimes referred to as the "untapering" meeting because the Committee decided to "await more evidence that progress will be sustained before adjusting the pace of its purchases"—the expected funds rate path was statistically indistinguishable from the June rate path (see the dashed black line in figure 1). However, the September announcement to delay the tapering of its purchases appeared to have caught bond investors by surprise. In figure 2, we see that the 10-year Treasury rate (the blue line) dropped by approximately 20 basis points over the coming weeks—all while the market's expectation for the timing of liftoff remained relatively constant.

Over the rest of 2013, the pace of the expected rate hikes stayed relatively stable. Figure 1 shows this stability by the similar curvature of the expected path lines from September to December. Interestingly, the December FOMC formal announcement that the Fed would begin to reduce its monthly purchases of Treasuries and mortgage-backed securities (MBS) by $5 billion each did not change the market's expectations for how long it would be before liftoff (see the solid black line in figure 1). We interpret this as market participants having formed their expectations about the future pace of interest rate hikes when the Treasury rates had increased and as policymakers were beginning to talk about tapering and not when the Fed announced the actual date and pace of its shrinkage in asset purchases.

Now compare figure 1 to the sequence of expected rate paths plotted in figure 3 for the time interval of November 5, 2020, to August 11, 2021. Early in this time period, the orange line in figure 2 shows the 10-year Treasury rate increasing 95 basis points from November 2020 to the end of March 2021 (the high point of the orange line in figure 2). This increase in the 10-year rate was due in part to the improving economic conditions and optimism around the advent of COVID-19 vaccines. This time period also corresponds with a steepening in the market expectations for the fed funds rate path seen in figure 3. The "lower for longer" policy of the Fed can be seen in the flat November FOMC rate path (compare the orange rate paths in figures 1 and 3). But as in figure 1, the expected rate paths in figure 3 gradually steepen while the 10-year rate is increasing.

Figure 3: Market Expectations for the Future Fed Funds Rate Path

Note: The fed funds rate path was computed from daily option data on Eurodollar futures contracts from November 5, 2020, to August 27, 2021. Each unlabeled line represents the market's expected path for monetary policy given the data as of Wednesday of the week

The minutes from the April FOMC were released to the public on May 19, 2021 (see the pink rate path in figure 3). These minutes describe several participants suggesting that "it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases." Discussion about shrinking the monthly purchases of assets continued into the June 2021 FOMC meeting. Importantly, at the June FOMC press conference, Fed chair Jerome Powell responded to a question about the timeline for reducing asset purchases by saying that people can think of the June meeting as the "talking about talking about" meeting.

The market's expectation about the fed funds rate path to this taper chatter was muted. Market expectations for the first rate hike had already moved up from the middle of 2024 to the first half of 2023. Given the similarity in the paths at the FOMC meetings in June (see the dotted black line in figure 3) and July (the dashed black line in figure 3), and after Chair Powell's Jackson Hole speech (the solid black line), market participants did not alter their expectations about liftoff. Not even the June FOMC's hawkish Summary of Economic Projections affected the views of market participants on the future course of interest rates.

Comparing the sequence of 2013 and 2020–21 rate paths plotted in figures 1 and 3, we might believe that those who think tapering in 2021 will lead to a similar market reaction as in 2013 are right—but only in the sense that both events corresponded to a sizeable increase in the 10-year Treasury rate and not the actual taper.

That being said, after the rate paths in figures 1 and 3 steepened, the limited impact that taper talk had on the rate paths lends support to those who expect tapering to be a nonevent. The relatively constant pace of expected rate hikes found in 2013 and 2021 suggests that a formal announcement by the Fed on reducing its purchases of Treasuries and agency MBS will likely have a limited effect on the market expectations for the pace of future rate hikes. This is especially true for the 18- to 24-month time horizon of the rate paths.

Regardless of whether we believe that there will or will not be a "taper tantrum" similar to the one in 2013, the market expectations calculated from the Eurodollar futures market clearly show two common effects from the events of 2013 and 2020–21. The first is that as the 10-year Treasury rate begins to rise, market participants expect the Fed to start raising the fed funds rate earlier than before. The second effect is that after the first effect, the expected pace of future rate hikes does not appear to be very responsive to taper talk. Hopefully, knowledge of these tapering-related empirical regularities will help market participants form more accurate predictions about future interest rate policies.

May 27, 2021

The Role of Central Banks in Fostering Economic and Financial Resiliency

The Atlanta Fed recently hosted its 25th annual Financial Markets Conference, with the theme of Fostering a Resilient Economy and Financial System: The Role of Central Banks. The conference addressed both the adequacy of the monetary policy toolkit and the role of the U.S. dollar (USD) in international financial markets. The conference included two keynote talks. The first day featured a keynote speech by Federal Reserve Board vice chair Richard Clarida, followed by a discussion with Atlanta Fed president Raphael Bostic. The second day began with an armchair discussion featuring Harvard professor Larry Summers and Atlanta Fed research director David Altig. A video of the conference is available here video fileOff-site link. This post reviews some of the highlights from the conference.

Keynote talks
Vice chair Clarida's keynote speechOff-site link focused on global factors that help determine the yield curve for sovereign bonds. Clarida observed that studies of domestic and major foreign government markets have found that most of the movements in the term structure of interest rates can be explained by the overall level of the curve and the slope of the curve. He then reviewed work suggesting that a global factor—one that is highly correlated with estimates of the neutral real interest rate—has a great influence on the level of the curve. Given this information, central banks may not have much ability to influence the yield curve's level unless they are willing to unanchor inflation expectations in their domestic market. Clarida then presented evidence that the slope of the U.S. yield curve is highly correlated with its monetary policy, specifically the deviation of the U.S. neutral nominal policy rate from the actual federal funds rate. He acknowledged that correlation does not equal causation but provided some evidence that central bank decisions (by the Fed and major foreign central banks) have a causal relationship with the slope of the yield curve. These observations led Clarida to conclude that "major central banks can be thought of as calibrating and conducting the transmission of policy...primarily through the slopes of their yield curves and much less so via their levels."

Professor Summers raised a variety of concerns about current policy and the risks to the financial system in his chat on the conference's second day. One of these concerns relates to the monetary policy projections, which suggest that inflation will remain sufficiently low so that the Fed's policy rate may not increase for several years. This expectation of low rates may create a "dangerous complacency," according to Summers, that will make it more difficult to raise rates. The result may be that nominal policy rates remain too low, producing higher inflation that leads to even lower real rates and even higher inflation. The result could be not only a "substantial pro-cyclical bias in financial conditions" but also a threat to financial stability if the low nominal rates result in excessive financial leverage.

Monetary policy panel session
The monetary policy toolkit received some scrutiny in a panel titled "Is the Monetary Policy Toolkit Adequate to Meet Future Challenges?" It was moderated by Julia Coronado, president of MacroPolicy Perspectives. Coronado promised a session with some provocative comments, and each of her panelists delivered. Among the problems addressed by the panelists was central banks' limited ability to counteract economic downturns. Historically, central banks have lowered their nominal interest rate target by several percentage points in response to the onset of a recession, or even the elevated risk of one. The continuing decline in nominal rates, however, has reduced central banks' ability to use rate reductions to fight recessions, instead forcing them to rely more on quantitative easing (or more accurately, large-scale asset purchases). Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics, and Willem Buiter, a visiting professor at Columbia University, provided two alternative ways of restoring the central bank's ability to lower nominal rates by more than 1 or 2 percentage points.

Gagnon's analysis was based on the Fisher equation, in which the nominal interest rate is approximately equal to the real rate of interest plus the rate of inflation. Gagnon observed that central banks, including the Fed, had set a target inflation rate of 2 percent back when the equilibrium real rate was higher (likely around 2 to 3 percent). Establishing this target rate resulted in equilibrium nominal interest rates around 4 to 5 percent, which gave central banks considerable room to respond to a recession. However, in the period since the inflation targets were set, equilibrium real rates have fallen by 1 to 2 percentage points. This decline greatly reduced central banks' ability to lower rates without taking them negative. Thus, to restore the ability of central banks to respond to higher inflation, Gagnon argued that central banks' inflation target should be increased to 3 to 4 percent.

Buiter implicitly started from the same point: that the decline in the equilibrium real rate had left central banks with too little room to cut interest rates. However, rather than raising the inflation target, Buiter argued that a better solution would be to accept deeply negative nominal interest rates. Several central banks in Europe, as well as the Bank of Japan, have lowered their rates below zero but never as much as 1 percent below zero. Buiter recommended that central banks take the steps necessary to be able to have deeply negative interest rates if that is appropriate for conditions.

Simon Potter, vice chairman at Millennium Management, noted an international dimension to the Fed's policy setting. Potter observed that many emerging markets had taken on considerably more debt to respond to the ongoing pandemic. He argued that these countries would need fast U.S. growth, and the accompanying increase in exports to the United States to be able to service their debt. Absent such increased debt service capacity, he pointed out that changes in the structure of these countries' debt markets would make rescheduling their debts even more difficult than it had been previously.

These provocative comments did not go unchallenged, however, as the other panelists raised concerns about the feasibility and/or desirability about each of these policy recommendations in the subsequent discussion that Coronado moderated.

Global dollar policy session
A panel on the conference's second day had the provocative title "Is the Financial System's Backbone, the U.S. Dollar, Also a Transmitter of Stress?" The panel's moderator was Federal Reserve Bank of Dallas president Robert Kaplan, who began the discussion by highlighting the importance of the USD in both international trade and international financial markets.

Stanford University Professor Arvind Krishnamurthy's presentation Adobe PDF file format supplied further evidence on the importance of the USD in trade and financial markets. He suggested that the USD's important role resulted in it providing a convenience yield to its users, which resulted in lower USD interest rates for those borrowing USD—both domestic and foreign borrowers. These lower rates, however, came with some financial risks, according to Krishnamurthy. For one, lower rates may induce greater financial leverage in U.S. borrowers. Additionally, foreigners who borrow USD to take advantage of the lower rates may be creating a mismatch between the currency they receive as revenue (especially from sales in their domestic markets) and the USD they need to repay their debt.

Thomas Jordan, chairman of the governing board of the Swiss National Bank, also noted the dominance of the USD in international markets and discussed its implications from the Swiss point of view. He noted two ways in which Switzerland is especially vulnerable to developments regarding USD. First, Swiss banks hold substantial amounts of USD assets and liabilities. Second, the Swiss franc is a safe haven currency that experiences increased demand in times of international financial stress. These result in Switzerland having a strong interest in global financial stability and especially in the stability of USD-funding markets. In this respect, Jordan observed that the Federal Reserve's swap lines with other central banks, including the Swiss National Bank, has been "very crucial." The swap lines provide an important liquidity backstop that recently proved valuable during the COVID-19 crisis.

Michael Howell, the managing director at CrossBorder Capital, focused on the potential for another currency to displace the USD in international markets. In his presentation Adobe PDF file format, he argued we should not be "shortsighted" in dismissing other currencies. In particular, he pointed to China, saying that China sees the USD as a rival and wants to displace it, particularly in Asia. He then went on to discuss some of the steps that China would need to take—and is taking—to displace the USD.

After these remarks by the panelists, Kaplan moderated a question-and-answer session that took a closer look at these and other issues.

January 8, 2020

Is There a Taylor Rule for All Seasons?

In September 2016 we introduced the Taylor Rule Utility, a tool that allows a user to plot the federal funds rate against the prescription from an equation called the Taylor rule, shown below:

equation called the Taylor rule

Broadly speaking, the Taylor rule translates readings of inflation (πt) and resource slack (gapt)—often measured by comparing real gross domestic product (GDP) or the unemployment rate to some measure of its "potential" or "natural" level—into a recommended setting for the fed funds rate. The default settings of the rule as of September 2016 (incorporated in the blue dashed line in the chart below) were, apart from some minor differences in variable choices, consistent with the settings used in John Taylor’s landmark 1993 paper that introduced the Taylor rule.

Actual Federal Funds Rate and Taylor Rule Prescriptions

As the chart shows, for most of this decade, the funds rate prescription from this original Taylor rule consistently exceeded the actual rate by 1 to 3 percentage points, and as Wall Street Journal columnist Michael Derby noted last August, the prescription was well above the actual funds rate in the third quarter of 2019. Much of this difference can be explained by the setting of the natural (real) interest rate, or r*, in the above equation. Taylor set r* at 2 percent in his original rule based on average real GDP growth since 1984 and, according to estimates from the Laubach-Williams (LW) model, 2 percent continued to be a reasonable, if slightly low, estimate of r* up until the 2007–09 recession. Since 2009, estimates of r* from the LW model have generally hovered between 0 and 1 percentage point. Since July 2017, the semiannual Monetary Policy Report from the Board of Governors to Congress has included a section on monetary policy rules. And in these sections, r* has been estimated with the consensus long-run projection of a short-term interest rate from Blue Chip Economic Indicators. Since 2015, these Blue Chip interest rate projections have also been consistent with estimates of r* between 0 and 1 percent.  

Setting r* to the LW model estimate (instead of 2 percent) in the Taylor rule results in a prescription corresponding to the solid blue line in the above chart. We can see this line is much closer to the actual fed funds rate for most of this decade. Nevertheless, it’s not clear that rules using LW-model estimates of r* and Congressional Budget Office (CBO) estimates of potential GDP or the natural unemployment rate are the most relevant for monetary policymakers. For example, in the December 2019 Summary of Economic Projections (SEP), the central tendency of Federal Open Market Committee (FOMC) participants’ longer-run projections of the unemployment rate was 3.9 to 4.3 percent. Conversely, the CBO’s latest estimate of the natural unemployment rate in the fourth quarter of 2019 rounds up to 4.6 percent, while its latest estimate of the natural rate in 2025 rounds up to 4.5 percent. The orange line in the chart above uses the FOMC/SEP longer-run projections of the fed funds rate and the unemployment rate.

Both the LW/CBO and FOMC/SEP variants of the Taylor 1993 rule prescribed an earlier "liftoff" of the fed funds rate than actually occurred. Former Fed chairs Ben Bernanke and Janet Yellen have sometimes referred to an alternative rule known as Taylor 1999. The FOMC/SEP Taylor 1999 rule, which puts twice as much weight on the resource gap as the FOMC/SEP Taylor 1993 rule, is the green line in the above chart that is identical to the orange line apart from a doubling of the resource gap coefficient in the above equation. This rule prescribed a later liftoff date than the other rules depicted in the chart. Because of the low unemployment rate, its current funds rate prescription is now above the rate that the FOMC/SEP 1993 rule prescribes.

By now, it’s probably clear that the answer to the question I posed in this blog post’s title is no, there is not a Taylor rule for all seasons—or at least not one that would satisfy everybody. For this reason, we have modified the interactive chart in our Taylor Rule Utility to show prescriptions from up to three versions of the Taylor rule. The default settings of these three rules in the interactive chart coincide exactly with the solid blue, orange, and green lines in the above figure. But you can modify all of the rules to generate, for example, the dashed blue Taylor 1993 line shown above. We hope that users find this a useful enhancement to the tool.

June 24, 2019

Mapping the Financial Frontier at the Financial Markets Conference

The Atlanta Fed recently hosted its 24th annual Financial Markets Conference, whose theme was Mapping the Financial Frontier: What Does the Next Decade Hold? The conference addressed a variety of issues pertinent to the future of the financial system. Among the sessions touching on macroeconomics was a keynote speech on corporate debt by Federal Reserve Board chair Jerome Powell and another on revitalizing America by Massachusetts Institute of Technology (MIT) professor Simon Johnson. The conference also included a panel discussion of the Fed's plans for implementing monetary policy in the future. This macroblog post reviews these macroeconomic discussions. A companion Notes from the Vault post reviews conference sessions on blockchain technology, data privacy, and postcrisis developments in the markets for mortgage backed securities.

Chair Powell's thoughts on corporate debt levels
Chair Powell's keynote speech focused on the risks posed by increases in corporate debt levels. In his speech, titled "Business Debt and Our Dynamic Financial System" (which you can watch or read), Powell began by observing that business debt levels have increased by a variety of measures including the ratios of debt to gross domestic product as well as the debt to the book value of corporate assets. These higher debt ratios alone don't currently pose a problem because corporate profits are high and interest rates are low. Powell noted some reasons for concern, however, including the reduced average quality of investment-grade bonds, with more corporate debt concentrated in the "lowest rating—a phenomenon known as the 'triple-B cliff'".

Powell noted several differences between the recent increase in corporate debt and the increase in household debt prior to the 2007–09 crisis that offset these risks. These differences include a more moderate rate of increase in corporate debt, the lack of a feedback loop from debt levels to asset prices, reduced leverage in the banking system, and less liquidity risk.

Powell concluded his remarks by saying that although business debt does pose a risk of amplifying a future downturn, it does not appear to pose "notable risks to financial stability." Finally, he noted that the Fed is working toward a more thorough understand of the risks.

Simon Johnson on jumpstarting America
Simon Johnson started his keynote speech by discussing Amazon's search for a second headquarters city. The company received proposals from 238 cities across the country (and Canada). However, in the end, it selected two large metropolitan areas—New York and Washington, DC—that were already among the leaders in creating new tech jobs. Although many places around the country want growth in good jobs, he said the innovation economy is "drawn disproportionately to these few places."

Johnson's remedy for this disproportionate clustering is for the federal government to make a deliberate effort to encourage research and development in various technical areas at a number of research universities around the country. This proposal is based on his book with fellow MIT economist Jonathan Gruber. They argue that the proposal encourages "exactly what the U.S. did in the '40s, '50s, and '60s," which was to help the United States develop new technology to be used in World War II and the Cold War.

Johnson proposed that the funding for new technical projects be allocated through a nationwide competition that intentionally seeks to create new tech hubs. In making his case, Johnson observed that the view that "all the talent is just in six places is fundamentally wrong." Johnson said that he and his coauthor found 102 cities in 36 states that have a substantial proportion of college graduates and relatively low housing prices. Moreover, Johnson observed that existing tech centers' cost of living has become very high, and those cities have substantial political limits on their ability to sustain new population growth. If some of these 102 potential hubs received the funding to start research and provide capital to business, Johnson argued, overall growth in the United States could increase and be more evenly distributed.

Discussing the implementation of monetary policy
The backdrop for the session on monetary policy implementation was postcrisis developments in the Fed's approach to implementing monetary policy. As the Fed's emergency lending programs started to recede after the crisis, it started making large-scale investments in agency mortgage backed securities and U.S. Treasuries. This program, widely (though somewhat misleadingly) called "quantitative easing," or QE, pumped additional liquidity into securities markets and played a role in lowering longer-term interest rates. As economic conditions improved, the Fed first started raising short-term rates and then adopted a plan to shrink its balance sheet starting in 2018. However, earlier this year, the Fed announced plans to stop shrinking the balance sheet in September if the economy performs as it expected.

Julia Coronado, president of MacroPolicy Perspectives, led the discussion of the Fed's plans, and a large fraction of that discussion addressed its plans for the size of the balance sheet. Kevin Warsh, former Federal Reserve governor and currently a visiting fellow at Stanford University's Hoover Institution, provided some background information on the original rationale for QE, when many financial markets were still rather illiquid. However, he argued that those times were extraordinary and that "extraordinary tools are meant for extraordinary circumstances." He further expressed the concern that using QE at other times and for other reasons, such as in response to regulatory policy, would increase the risk of political involvement in monetary policy.

During the discussion, Chicago Fed president Charles Evans argued that QE is likely to remain a necessary part of the Fed's toolkit. He observed that slowing labor force growth, moderate productivity growth, and low inflation are likely to keep equilibrium short-term interest rates low. As a result, the Fed's ability to lower interest rates in a future recession is likely to remain constrained, meaning that balance sheet expansion will remain a necessary tool for economic stimulus.

Ethan Harris, head of global economics research at Bank of America Merrill Lynch, highlighted the potential stress the next downturn would place on the Fed. Harris observed that "other central banks have virtually no ammunition" to fight the next downturn, a reference to the negative policy rates and relatively larger balance sheets of some other major central banks. This dynamic prompted his question, "How is the Fed, on its own, going to fight the next crisis?"

The conference made clear the importance of the links between financial markets and the macroeconomy, and this blog post focused on just three of them. I encourage you to delve into the rest of the conference materials to see these and other important discussions.