What Lies Ahead for the Federal Reserve

A recent speech by Janet Yellen gives us a very clear idea of what lies ahead for the U.S. economy and the Federal Reserve during the next (and already overdue when looking at averages) recession.  The speech, given on October 20, 2017, was entitled "A Challenging Decade and a Question for the Future" looks at the Fed's progress in defeating the Great Recession over the past decade and how the Fed will fight future economic contractions.

Let's look at some key quotes from her speech starting with her rationale for using unconventional monetary policies during and after the Great Recession and the effectiveness of these policies::

"A substantial body of evidence suggests that the U.S. economy is much stronger today than it would have been without the unconventional monetary policy tools deployed by the Federal Reserve in response to the Great Recession. Two key tools were large-scale asset purchases and forward guidance about our intentions for the future path of short-term interest rates. The rationale for those tools was straightforward: Given our inability to meaningfully lower short-term interest rates after they reached near-zero in late 2008, the FOMC used increasingly explicit forward rate guidance and asset purchases to apply downward pressure on longer-term interest rates, which were still well above zero.

The FOMC's goal in lowering longer-term interest rates was to help the U.S. economy recover from the recession and stem the disinflationary forces that emerged from it. Some have suggested that the slow pace of the economic recovery proves that our unconventional policy tools were ineffective. However, one should recognize that the recovery could have been much slower in the absence of our unconventional tools. Indeed, the evidence strongly suggests that forward rate guidance and securities purchases--by substantially lowering borrowing costs for millions of American families and businesses and making overall financial conditions more accommodative--did help spur consumption and business spending, lower the unemployment rate, and stave off disinflationary pressures." (my bold)

Here is a graphic showing what has happened to the Fed's balance sheet since 2006:

As we can see from this graphic, despite the Fed's "heroic measures" since the Great Recession began in late 2007, economic growth in the latest cycle has been rather poor compared to other cycles:

So, what lies ahead for the Federal Reserve?  Given that we are currently experiencing the third longest expansion since the end of the Second World War and that, at 103 months long, the current expansion is well above the average economic expansion length of 67 months as shown on this graphic:

...the Federal Reserve has to be considering what it will do when the economy starts to slow.  Here's what Ms. Yellen had to say about the future:

"My colleagues on the FOMC and I believe that, whenever possible, influencing short-term interest rates by targeting the federal funds rate should be our primary tool. As I have already noted, we have a long track record using this tool to pursue our statutory goals. In contrast, we have much more limited experience with using our securities holdings for that purpose.

Where does this assessment leave our unconventional policy tools? I believe their deployment should be considered again if our conventional tool reaches its limit--that is, when the federal funds rate has reached its effective lower bound and the U.S. economy still needs further monetary policy accommodation.

Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades.   Indeed, most FOMC participants now assess the longer-run value of the neutral federal funds rate as only 2-3/4 percent or so, compared with around 4-1/4 percent just a few years ago.   With a low neutral federal funds rate, there will typically be less scope for the FOMC to reduce short-term interest rates in response to an economic downturn, raising the possibility that we may need to resort again to enhanced forward rate guidance and asset purchases to provide needed accommodation...

The bottom line is that we must recognize that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound." (my bold)

It is interesting to see that Ms. Yellen admits that the Federal Reserve has "much more limited experience with using its securities holdings" to influence interest rates.  Her final statement is also quite telling.  Even though the Fed is inexperienced with quantitative easing, she clearly believes that the Federal Reserve will be forced to use unconventional monetary policies once again, even in the case of a moderate recession.  Odds are quite good that the Fed will still have a massively bloated balance sheet when it is forced to go back into the market and load up with additional Treasuries and other fixed income products and, given Japan's failure to stimulate its own economy with its even greater use of unconventional monetary policies, there is no guarantee that the Fed will meet with success the next time it needs to prod a contracting economy back to life.

Despite the fact that the Federal Reserve has no real idea about the impact of the unwinding of its $4.47 trillion inventory of Treasuries and mortgage-backed securities, it is already admitting that it will likely have to continue its experiment with quantitative easing during the next recession, even if it is a mild contraction.  As well, even though a decade and a half of QE hasn't cured the ills that plague the Japanese economy, it's full steam ahead for the Fed.

Janet Yellen on the Federal Debt

In Janet Yellen's most recent testimony before Congress, a little-covered comment gives us a sense of warning about where Washington's fiscal policies are leading us.  Here's the exchange:

Unfortunately, Ms. Yellen's comments are cut off before they are complete.  As such, here's the transcript of the exchange:

Mr. Steven Pearce (R - NM 2nd District):  I'm going though the Monetary Policy Report here and I'm going through your comments and I almost don't see anything about that number on the screen behind you that's just constantly rolling there and it's the debt .  Maybe it does not mean anything and sorta maybe it does.  Do you all ever talk about that in your committee?  Do you ever contemplate that in your position?

Ms. Yellen:  Well, I've discussed this previously with this committee and know there's....

Mr. Pearce:  I understand but we didn't get it in the report today as one of the driving factors and is something we ought to be thinking about.  So, how did it affect you all when Illinois was downgraded, their bond rating was downgraded the first of the year and they are paying what one analyst said is the highest differential in our history (Illinois bonds are currently rated at just above "junk status" - the current yield is 4.4 percent, 2.5 percentage points more than the yield on top-rated debt).  Now that's...the reason they are having to pay more and the bonds being downgraded is because they can't afford to pay the bills basically and if you hold their bond, you may not get paid.  If you went back to Detroit when it filed bankruptcy, bondholders only got 74 percent on the dollar.and so... and, I mean, it all feeds back toward this number here and the fact that it doesn't even make the print, not even the fine print that I could find, maybe I missed it but I did see the one sentence about Illinois being downgraded and there was brief discussion about Puerto Rico but the idea that we as a country are not discussing our ability to pay our bills is something that, I think there's a downside effect to the problem but the fact that your report doesn't bring it up is a little concerning to me.  And, the way that really played out was a couple of weeks ago when Chicago schools tried to issue a bond rating and they didn't get any bidders at all...none.  So, they ended up driving the rate up to seven, seven and a half, seven and three quarters or something (according to Bloomberg, the yield on Chicago school system variable rate bonds jumped to a maximum of 9 percent).  But it seems like that the people in charge of the financial stability of the country, the value of our dollar, the value of our promises to pay, it just seems like it would have little bit more importance in the document here.   I would expect, frankly, maybe a whole chapter because there are estimates that we cannot pay our bills in this country and so we continue to operate as if it's not going to matter if our ratings are downgraded.   If our interest rate goes up.  We're already running deficits which means we have to print the money every year in which to operate and it seems that the people in charge of the system would be talking about it and postulating and telling us "Hey, this is kind of serious.  Why don't we all work together and start figuring out what we can do to live within our means to just make sure that we're not paying  triple and quadruple what other people are paying for debt."  I'd love to hear your comments.

Ms. Yellen: Well, let me state in the strongest possible terms I agree that what you're showing here represents a trend that given current spending and taxation decisions is going to lead to an unsustainable debt situation with rising interest rates and declining investment in the United States that will further harm productivity growth and living standards.  I believe key thing that Congress should be taking into account in designing fiscal policy is the need to achieve sustainability of this debt path over time.  This is something I'm not just saying today but have been emphasizing for some time in my testimony.  (my bold)

You can find the remainder of Ms. Yellen's comments that are not included in the first video at the 52 minute 50 second mark here. 

Let's look at what has happened to the total federal debt since 1976:

Here is what has happened to the federal debt held by the public (marketable debt) since 1970:

This debt excludes the debt that the federal government owes to itself (i.e. intergovernmental debt that is owed to government departments - non-marketable debt)

Here is a graphic from the Treasury showing the amounts of both marketable and non-marketable debt effective June 30, 2017:

Here is a table showing annual federal government spending on interest payments going back to 1988 along with a breakdown of the interest expense on a monthly basis for the first nine months of fiscal 2017:

Notice how the interest owing on the federal debt  has not grown significantly over the past decade?  That's a direct result of this:

If we go back one decade to June 2007, a few months prior to the Federal Reserve's now long-term experiment with near-zero interest rates, we find this:

As Ms. Yellen noted, the U.S. government could find itself in an unsustainable debt situation.  With the current debt consisting of $14.363 trillion in marketable debt, a rise in interest rates from the current 2 percent to 5 percent (as shown in the examples above), interest owing on the marketable debt alone would rise from $287 million annually to $718 million.  If we add in the non-marketable (intragovernmental) which brings the total debt up to $19.845 trillion, the interest owing on the debt would rise from $389.7 billion to $992 billion or nearly one and a half times what the Pentagon proposes to spend in fiscal 2017.

While the U.S. dollar is the presently the global currency of choice, any number of factors could change this perception, including a war with Russia or China or both.  In large part, thanks to the beneficence of the Federal Reserve, Washington's power base is living in a false reality where overspending is never punished and ever-mounting levels of debt are considered a normal part of doing business.  We shall see.

One wonders - how does the braintrust at the Federal Reserve sleep at night given the fiscal mess that they are helping to create?  While Ms. Yellen may say that she's brought this to the attention of Congress in the past, her voice (and that of her predecessors at the helm of the Fed) have actually been quite silent when it comes to Washington and its unsustainable debt situation.  

Negative Interest Rates - How Low Could They Go?

A speech given by Janet Yellen at the Jackson Hole, Wyoming "Designing Resilient Monetary Policy Frameworks for the Future" provides us with a glimpse into how the Federal Reserve will tackle the next recession.

Let's start with this quote:

"My focus today will be the policy tools that are needed to ensure that we have a resilient monetary policy framework. In particular, I will focus on whether our existing tools are adequate to respond to future economic downturns. As I will argue, one lesson from the crisis is that our pre-crisis toolkit was inadequate to address the range of economic circumstances that we faced. Looking ahead, we will likely need to retain many of the monetary policy tools that were developed to promote recovery from the crisis. In addition, policymakers inside and outside the Fed may wish at some point to consider additional options to secure a strong and resilient economy."


In her speech, Ms. Yellen notes that the FOMC expects moderate real growth in GDP and that inflation will rise to 2 percent over the next few years.  Despite the Fed's best efforts, as you can see on this graph, inflation as measured using Personal Consumption Expenditures (PCE) remains uncomfortably below the Fed's target:

The last time the year-over-year increase in PCE was in excess of 2 percent was back in early 2012 when it hit 2.1 percent for a very short time.

Now that we've looked at the inflation conundrum, let's look at another quote from Ms. Yellen's speech:

"And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight. For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide..."  

In fact, here's how wide the  70 percent probability projections for the federal funds rate are with the median pathway shown as a dark line:

That's a spread of 4.5 percentage points between the low and high estimates by the time we get out to the end of 2018.  I guess that allows the FOMC to cover themselves for just about any contingency!

Now, let's look at Ms. Yellen's comments on the Federal Reserve's toolkit prior to the Great Recession

"Prior to the financial crisis, the Federal Reserve's monetary policy toolkit was simple but effective in the circumstances that then prevailed. Our main tool consisted of open market operations to manage the amount of reserve balances available to the banking sector.  These operations, in turn, influenced the interest rate in the federal funds market, where banks experiencing reserve shortfalls could borrow from banks with excess reserves. Before the onset of the crisis, the volume of reserves was generally small--only about $45 billion or so.  Thus, even small open market operations could have a significant effect on the federal funds rate. Changes in the federal funds rate would then be transmitted to other short-term interest rates, affecting longer-term interest rates and overall financial conditions and hence inflation and economic activity. This simple, light-touch system allowed the Federal Reserve to operate with a relatively small balance sheet--less than $1 trillion before the crisis--the size of which was largely determined by the need to supply enough U.S. currency to meet demand."

The problem with this "simple monetary policy toolkit" was that it meant that the Fed could no longer control the federal funds rate when bank reserves were no longer scarce, largely because banks simply weren't lending.  This meant that the Federal Reserve had to create programs that would keep credit flowing to both households and Corporate America.  Even with those actions, bank reserves still kept growing, resulting in the Fed nearly losing control over its own interest rate policies.  This meant that the Federal Reserve had to lower the target for the federal funds rate to near zero where it has been ever since, a drop of five percentage points over its previous level as you can see on this graph:

Now, let's look at the most interesting comments of the speech:

"Nonetheless, a variety of policy benchmarks would, at least in hindsight, have called for pushing the federal funds rate well below zero during the economic downturn.  That doing so was impossible highlights the second serious limitation of our pre-crisis policy toolkit: its inability to generate substantially more accommodation than could be provided by a near-zero federal funds rate."

Let me repeat that; if the Fed had only used its traditional influence over the federal funds rate to prop up the economy, it would have had to push interest rates well below zero.

It's at this point that readers of Ms. Yellen's speech have to note the small "8" that comes after the highlighted sentence.  It refers to a note which is attached to the bottom of the speech as quoted here (and please pardon the inclusion of the policy rule equation and focus on the highlighted portion):

"Consider the following policy rule: R(t) = R* + p(t) + 0.5[p(t)-p*]-2.0[U(t)-U*], where R is the federal funds rate, R* is the longer-run normal value of the federal funds rate adjusted for inflation, p is the four-quarter moving average of core PCE inflation, p* is the FOMC's target for inflation (2 percent), U is the unemployment rate, and U* is the longer-run normal rate of unemployment. Based on the medians of FOMC participants' latest longer-run projections, R* is approximately 1 percent and U* is about 4.8 percent. Accordingly, with the unemployment rate climbing to 10 percent and core PCE inflation falling to 1 percent in 2009, this rule would have prescribed lowering the federal funds rate to minus 9 percent at the depths of the recession. In contrast, the standard Taylor rule, which is half as responsive to movements in resource utilization, would have prescribed lowering the federal funds rate to minus 3-3/4 percent using the same estimates for R* and U*."  

Basically, what Ms. Yellen is telling us is that, without the creative use of quantitative easing and other non-traditional monetary policies like forward guidance and "The Twist", the Federal Reserve would have been powerless to breathe life back into the near-dead economy unless interest rates had dropped to between -3.75 and -9 percent!

Let's close this posting with an observation; given that several of the world's influential central banks, most particularly Japan, have had to resort to the use of negative interest rates in a last ditch effort to restart their sluggish economies and spark some inflation and with the added complication of a lethargic global and American economy, the Federal Reserve will have to be even more creative during the next recession since their non-traditional policies have been less than spectacularly successful since 2008.  My guess is that negative interest rates are sure to appear on this side of the Atlantic and Pacific Oceans since they seem to be the current choice of desperate and monetarily cornered central bankers and Ms. Yellen's speech shows us that the Fed is at least considering the potential impact of negative rates on the American economy.