Macroblog

November 20, 2013

The Shadow Knows (the Fed Funds Rate)

The fed funds rate has been at the zero lower bound (ZLB) since the end of 2008. To provide a further boost to the economy, the Federal Open Market Committee (FOMC) has embarked on unconventional forms of monetary policy (a mix of forward guidance and large-scale asset purchases). This situation has created a bit of an issue for economic forecasters, who use models that attempt to summarize historical patterns and relationships.

The fed funds rate, which usually varies with economic conditions, has now been stuck at near zero for 20 quarters, damping its historical correlation with economic variables like real gross domestic product (GDP), the unemployment rate, and inflation. As a result, forecasts that stem from these models may not be useful or meaningful even after policy has normalized.

A related issue for forecasters of the ZLB period is how to characterize unconventional monetary policy in a meaningful way inside their models. Attempts to summarize current policy have led some forecasters to create a "virtual" fed funds rate, as originally proposed by Chung et al. and incorporated by us in this macroblog post. This approach uses a conversion factor to translate changes in the Fed's balance sheet into fed funds rate equivalents. However, it admits no role for forward guidance, which is one of the primary tools the FOMC is currently using.

So what's a forecaster to do? Thankfully, Jim Hamilton over at Econbrowser has pointed to a potential patch. However, this solution carries with it a nefarious-sounding moniker—the shadow rate—which calls to mind a treacherous journey deep within the hinterlands of financial economics, fraught with pitfalls and danger.

The shadow rate can be negative at the ZLB; it is estimated using Treasury forward rates out to a 10-year horizon. Fortunately we don't need to take a jaunt into the hinterlands, because the paper's authors, Cynthia Wu and Dora Xia, have made their shadow rate publicly available. In fact, they write that all researchers have to do is "...update their favorite [statistical model] using the shadow rate for the ZLB period."

That's just what we did. We took five of our favorite models (Bayesian vector autoregressions, or BVARs) and spliced in the shadow rate starting in 1Q 2009. The shadow rate is currently hovering around minus 2 percent, suggesting a more accommodative environment than what the effective fed funds rate (stuck around 15 basis points) can deliver. Given the extra policy accommodation, we'd expect to see a bit more growth and a lower unemployment rate when using the shadow rate.

Before showing the average forecasts that come out of our models, we want to point out a few things. First, these are merely statistical forecasts and not the forecast that our boss brings with him to FOMC meetings. Second, there are alternative shadow rates out there. In fact, St. Louis Fed President James Bullard mentioned another one about a year ago based on work by Leo Krippner. At the time, that shadow rate was around minus 5 percent, much further below Wu and Xia's shadow rate (which was around minus 1.2 percent at the end of last year). Considering the disagreement between the two rates, we might want to take these forecasts with a grain of salt.

Caveats aside, we get a somewhat stronger path for real GDP growth and a lower unemployment rate path, consistent with what we'd expect additional stimulus to do. However, our core personal consumption expenditures inflation forecast seems to still be suffering from the dreaded price-puzzle. (We Googled it for you.)

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Perhaps more important, the fed funds projections that emerge from this model appear to be much more believable. Rather than calling for an immediate liftoff, as the standard approach does, the average forecast of the shadow rate doesn't turn positive until the second half of 2015. This is similar to the most recent Wall Street Journal poll of economic forecasters, and the September New York Fed survey of primary dealers. The median respondent to that survey expects the first fed funds increase to occur in the third quarter of 2015. The shadow rate forecast has the added benefit of not being at odds with the current threshold-based guidance discussed in today's release of the minutes from the FOMC's October meeting.

Moreover, today's FOMC minutes stated, "modifications to the forward guidance for the federal funds rate could be implemented in the future, either to improve clarity or to add to policy accommodation, perhaps in conjunction with a reduction in the pace of asset purchases as part of a rebalancing of the Committee's tools." In this event, the shadow rate might be a useful scorecard for measuring the total effect of these policy actions.

It seems that if you want to summarize the stance of policy right now, just maybe...the shadow knows.

By Pat Higgins, senior economist, and

Brent Meyer, research economist, both of the Atlanta Fed's research department

• November 20, 2013 in
  • Fed Funds Futures
  • Federal Reserve and Monetary Policy
  • Forecasts
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  • Monetary Policy
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May 23, 2012

The three faces of postcrisis monetary policy

The latest edition of the San Francisco Fed's Economic Letter (written by Michael Bauer)has a nice review of the different channels through which the Fed's Large Scale Asset Purchase (LSAP) programs—QE, or quantitative easing more popularly—are thought to work:

"Central bank LSAPs potentially may affect interest rates through at least three channels. Notably, all three channels can broadly affect longer-term interest rates, extending beyond those securities that the central bank announces it will purchase:

• A portfolio balance channel, because the supply of long-maturity bonds available to private investors is reduced. The reduced supply of longer-term securities targeted by the Fed lowers the amount of interest rate risk in investor portfolios. That in turn decreases the risk premium that they require to hold both the targeted securities and other assets of similar duration. Longer-term interest rates are lowered across the board as a result. Gagnon et al (2011) emphasize this channel for QE1.
• A signaling channel, which arises when the Fed's announcements are interpreted as signals of its intent to hold down short-term interest rates further into the future. Bauer and Rudebusch (2011) argue that this channel played an important role for QE1.
• A market functioning channel, because QE1 provided relief when conditions in financial markets were dire, liquidity very low, and panic widespread. The Fed's intervention calmed investor fears. Thus, the intervention substantially supported a range of asset prices, including MBS and corporate bonds, lowering their yields."

The article references include links to the Gagnon et al. paper and the Bauer and Rudebusch paper, but none to any studies addressing the "market functioning channel." So I'll provide one: "Did the Federal Reserve's MBS Purchase Program Lower Mortgage Rates?" by Diana Hancock and Wayne Passmore, both senior staff members for the Federal Reserve of Board of Governors. According to Hancock and Passmore, the market functioning channel is key to appreciating the impact of QE1:

"We use empirical pricing models for MBS yields in the secondary mortgage market and for mortgage rates paid by homeowners in the primary mortgage market to measure how distorted mortgage markets were prior to the Federal Reserve's intervention, and the course of market risk premiums during the restoration to normal market functioning...

"We argue that this return to normal pricing occurred because the Federal Reserve's announcement signaled a strong and credible government backing for mortgage markets in particular and for the financial system more generally...

"More specifically, we estimate that the Federal Reserve's MBS purchase program over the course of 16 months reestablished normal market pricing in the MBS market and resulted in lower mortgage rates of roughly 100 to 150 basis points for purchasing houses. Most of the decline in mortgage rates occurred between the announcement of the program, on November 25, 2008, and the implementation of the program in the first quarter of 2009. After this point, both mortgage rates and risk premiums remained relatively stable until the end of the Federal Reserve MBS purchase program."

Hancock and Passmore note that the portfolio balance channel may have played a role after the completion of the QE1 purchases once market functioning had normalized, but the biggest bang was that renormalization itself.

Bauer's observations align with Hancock and Passmore's conclusions:

"QE1 had very pronounced effects on interest rates. The key announcements led to decreases of close to one percentage point. The announcements not only lowered yields on targeted Treasury securities and MBS, but also on corporate bonds...

"The two other programs, QE2 and MEP [maturity extension program], also affected yields of securities that were not targeted for Fed purchases... Generally though, QE2 and MEP affected interest rates much less than QE1 did. One reason is that bond market functioning had largely returned to normal. In addition, expectations of future short-term interest rates were already very low when these programs were announced, leaving little room for further signaling effects. Finally, QE2 and MEP were smaller than QE1."

Earlier this week, in a speech delivered in Tokyo at the Institute of Regulation and Risk, Federal Reserve Bank of Atlanta President Dennis Lockhart provided his view on this evidence:

"In my view, these [the QE1] purchase programs played an important role in the transition away from the emergency lending facilities created earlier in the crisis. The emergency credit facilities worked well to stem the downward spiral of the immediate post-Lehman period. Financial markets began the process of repair during the first half of 2009 but were still suffering from relatively serious liquidity pressures. The QE1 operation sustained the liquidity support that had been previously provided by lending through the emergency facilities.

"Because asset purchases largely replaced emergency loans made during the crisis, the net increase in the Fed's balance sheet was relatively modest. In this sense, the quantitative easing label is misleading. The intent and effect of the policy was not to inject a new and sizable quantity of reserves into the economy. Rather, the effect was to sustain liquidity in still struggling and fragile financial markets, particularly those related to residential real estate. For that reason, I prefer the term ‘credit easing' to describe this policy action."

However, the smaller impact of QE2 leads Lockhart to a different conclusion regarding the largest contribution of that program:

"I view QE2 differently. The FOMC [Federal Open Market Committee] formally announced QE2 in November 2010, with its decision to purchase $600 billion in longer-term Treasury securities. However, the policy was signaled in an important speech from Federal Reserve Chairman Ben Bernanke in August of that year. The circumstances at the time were dominated by a falling trend in measured inflation, weakening inflation expectations, and rising probabilities of outright deflation. Each of these developments was effectively reversed as the expectations for QE2 took root, expectations that were ultimately validated by FOMC action.

"Unlike QE1, QE2 did materially expand the size of the Federal Reserve's balance sheet. In my view, this distinction is important. The intent and effect of the two rounds of asset purchases were different. QE1 served to maintain liquidity at a time when financial markets were exceptionally unsettled. In contrast, QE2 was a more traditional monetary action to preserve price stability."

In a sense, this places the effects of QE2 in the signaling channel category, albeit with an emphasis on inflation expectations rather than interest rates directly.

Bauer's article also covers post-QE2 policy—the maturity extension program (MEP, or "Operation Twist") and the insertion of specific calendar dates (currently at least late 2014) to provide forward guidance on the period of time that the FOMC anticipates that the federal funds rate will remain at exceptionally low levels. Lockhart also describes these policies in terms of the "signaling channel," though in these cases with interest rate effects front and center:

"In terms of intent and effect, I think of the explicit forward guidance and the MEP in similar terms. We have entered a phase of the recovery in which sustained monetary accommodation is warranted in order to preserve and advance what is still modest progress on employment and economic growth. Importantly, this modest progress is occurring in the context of what, for me, is acceptable performance with respect to our price stability mandate. Actions that reinforce the maintenance of policy accommodation are appropriate. It is through that lens that I view the MEP and explicit forward guidance on policy rates."

Lockhart's remarks provide his perspective on three somewhat distinct policy challenges—market dysfunction, disinflationary pressures, and a need to sustain monetary policy accommodation—that motivate his support for the three major policy initiatives of the postcrisis period:

"Let me summarize this brief tour of postcrisis monetary policy. I view the sequence of nontraditional monetary policy actions as tailored responses to the particular needs of the economy and financial system at the time they were implemented. My conclusion is that by and large policy actions have been appropriate to the diagnosis of circumstances at the time. And in my assessment they have worked pretty well."

In this light, President Lockhart delivers his policy punch line:

"I have reframed to some extent the original question of what more can be done around the point that policy actions must be matched to circumstances. The challenge policymakers face is judging appropriateness of a tool for circumstances. As popular as it might be in some quarters to rule out further LSAPs (QE3, as it is known), I do not think this option can be taken off the table. QE3 will work under the right circumstances. But I don't believe such circumstances prevail at this time."

By Dave Altig, executive vice president and research director at the Atlanta Fed

• May 23, 2012 in
  • Federal Reserve and Monetary Policy
  • Interest Rates
  • Monetary Policy
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January 6, 2012

In the interest of precision

As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):

"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."

A similar description appeared in the Journal yesterday (again, emphasis added):

"The Fed has just taken a historic step towards increasing its transparency and accountability by saying it will begin to release interest-rate projections several years out at the conclusion of its next policy meeting on Jan. 25. This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."

I added the emphasis in both of those passages because I think the highlighted language isn't quite right. Here is the actual language that appears in the FOMC minutes:

"In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.…

"… participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions."

The minutes are pretty clear about what this information is intended to convey…

"Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions."

…and what it is not intended to convey (here too, emphasis added):

"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"

In fact, the first Journal piece mentioned above does document some of the expressed concerns near the end of the article. For example:

"… some might mistakenly see the forecasts as an ironclad commitment, rather than a projection that could change as economy evolves."

That caveat does speak to concerns of some FOMC participants that the projections would establish a specific policy path. But the issue is about more than maintaining flexibility in the face of changing economic conditions. The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.

This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.

By Dave Altig, senior vice president and research director at the Atlanta Fed

• January 6, 2012 in
  • Fed Funds Futures
  • Federal Reserve and Monetary Policy
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September 30, 2011

Fed Treasury purchases: How big is big?

In his July 13 testimony to Congress, Federal Reserve Chairman Ben Bernanke discussed the large-scale asset purchase program to buy $600 billion of longer-term Treasury securities that started in November 2010 and was completed in June 2011. The chairman noted:

"The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program—like more conventional monetary policy—has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy."

Chairman Bernanke went on to observe in a footnote in his prepared remarks from that testimony:

"The Federal Reserve's recently completed securities purchase program has changed the average maturity of Treasury securities held by the public only modestly, suggesting that such an effect likely did not contribute substantially to the reduction in Treasury yields. Rather, the more important channel of effect was the removal of Treasury securities from the market, which reduced Treasury yields generally while inducing private investors to hold alternative assets (the portfolio reallocation effect). The substitution into alternative assets raised their prices and lowered their yields, easing overall financial conditions."

In a similar way, the maturity extension program—dubbed "Operation Twist" by some—announced by the Federal Open Market Committee last week is designed to further remove longer-term Treasury securities from the market, a move that, other things being equal, should put downward pressure on longer-term rates. Jim Hamilton at Econbrowser has taken a stab at estimating the effects and concludes that it is likely to be modest. Atlanta Fed President Dennis Lockhart shared a similar sentiment, described in more detail later in this posting, in a speech earlier this week.

So what share of outstanding marketable long-term Treasury securities (excluding those held to maturity on government accounts) does the Federal Reserve hold? The following chart shows that the Fed's share of marketable long-term securities with more than five years to maturity increased substantially as a result of the $600 billion asset purchase program between November 2010 and June 2011 (see the chart). This large run-up confirms the point made by Chairman Bernanke that this program removed a considerable supply of longer-term securities from the market (relative to what it would have been otherwise).

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The new maturity extension program will replace $400 billion of shorter-dated Treasury securities that the Fed holds with an equal face-value amount of longer-term securities, and this move will further increase the Fed's relative holdings of marketable longer-term Treasury securities. As President Lockhart noted in his speech, the impact of this program cannot be known precisely, but he expects it to have a modest, positive influence:

"The Fed's maturity extension program and additional mortgage-backed securities purchases are meant to further ease financial conditions ceteris paribus, other things being equal. Of course, other things almost certainly will not stay equal, and other factors will influence what really happens to rates and spreads as policy intent encounters the real world….

"In my view, the maturity extension program along with the MBS purchases represents a measured, incremental attempt to add more support to the recovery. It's not a fix for everything that ails the economy, but it should help."

By John Robertson, vice president and senior economist in the Atlanta Fed's research department

• September 30, 2011 in
  • Federal Reserve and Monetary Policy
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  • Monetary Policy
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