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How farsighted was the leadership at the Federal Reserve as the world economy was heading toward a steep decline more than five years ago? Outside the Fed's marble halls, the answers to that question are only now becoming known, and the verdict is perhaps surprisingly positive.
In December 2008, a few months after the Lehman Brothers collapse threw the world economy into crisis, participants in the Fed's steering group, the Federal Open Market Committee (FOMC), met to discuss their policy options. It was widely agreed that the conventional policy instrument, the federal funds rate target, would have to be lowered to zero. The big question was "what should we do next?" A recently released transcript of the meeting shows that the FOMC was already considering most of the monetary policy options that are still being debated by economists and pundits today. The transcript frequently mentions a package of 21 memos on monetary policy at the zero bound that were prepared by Fed staff just before the meeting. The Peterson Institute for International Economics has obtained those memos through the Freedom of Information Act and is making them available to the public on its website as of today. In the interest of full disclosure, I was a coauthor of three of those background memos.
Together, the transcript and background memos display that FOMC participants understood the severity of the economic outlook they faced and that they and their staff had a good grasp of the pros and cons of the options available. That is not to say that Fed policy over the past few years could not have been improved upon, but simply to recognize that the Fed was not flying blind and indeed was already cognizant of many of the issues that would come to dominate the public debate about monetary policy.
Is 0.25 Zero?
The primary tool the Fed had to achieve its federal funds rate target at that time was the interest rate on bank reserves at the Fed, which was 1 percent in early December 2008. Almost all participants wanted to lower this rate and a few argued for a rate of zero percent. But most wanted a rate slightly above zero and they settled on 0.25 percent, which has remained constant to this day. The primary reason for a rate slightly above zero was concern that banks and money market funds needed to earn a spread between deposit and lending rates in order to pay their operating costs and they would find it difficult to impose negative interest rates on their depositors. In addition, there was some concern about reduced liquidity and disruptions in the bond markets that were already evident at low interest rates. The possible harm from further disruptions in banking and securities markets was judged to outweigh any small macroeconomic benefit from an even lower interest rate.
The FOMC did not discuss the possibility of a negative interest rate on bank reserves, but it is widely agreed that a significantly negative interest is not feasible because banks would convert their reserve balances to paper currency. A lingering puzzle is why the Fed never lowered interest on reserves to zero in subsequent years, when financial strains had diminished and depositors and market participants had gotten used to the low rate environment, but standard macroeconomic models imply that the benefits of such a small decline would have been correspondingly small.
Raising Inflation Expectations
The FOMC discussion shows that there was little appetite for a dramatic push to increase inflation expectations, with some participants expressing doubt that the Fed could raise expectations substantially through statements about its intentions without any additional actions. But there was also an acknowledgment that the Fed had not been as clear as it could have been about what inflation rate it aimed to achieve. Speeches and other published materials seemed to show a comfort zone for inflation with a lower end around 1 to 1.5 percent and an upper end at 2 percent. One of the background memos assumed an inflation goal of 1.75 percent. Participants did not agree on a common inflation goal at this meeting.
The FOMC eventually did adopt a common goal of 2 percent inflation at the January 2012 meeting, which is at the high end of the narrow range that had been widely perceived by the markets. In recent years some economists have made the case for a temporary or permanent inflation target as high as 4 or 5 percent, but Fed officials have made it clear that such a change has not been taken seriously within the FOMC.
Communication about Future Policy
There was widespread agreement within the FOMC about the benefits of telling financial markets that the policy rate was likely to stay near zero for some time, and the meeting statement included words to that effect. There was already the beginning of a debate as to whether the language should be cast in terms of future economic conditions or length of calendar time. This debate has reappeared on more than one occasion since then.
There was some discussion, both within the meeting and in the background memos, about the possible benefits of committing to hold the policy rate low for so long that the economy would be likely to overshoot the long-run desired levels of employment and inflation temporarily. Some participants questioned the credibility of such a commitment, given the likelihood that the Fed would come to regret it later. More generally, FOMC participants seemed to have little appetite for tying their hands in such a dramatic fashion. Although they were all for getting back to their economic goals quickly, they had no desire to speed up the recovery at the expense of overshooting their goals.
Liquidity Facilities as a Monetary Tool
There was widespread approval of the Fed's generous provision of liquidity during the crisis, with some participants noting that measures of financial stress were beginning to ease a bit. Both the discussion and one of the background memos agreed that the liquidity facilities had a macroeconomically important effect to the extent that they were preventing cutbacks in consumption and investment that would otherwise have occurred. Some noted that these facilities were less effective at providing additional stimulus than they were at offsetting negative shocks because market participants could not be coerced into using these facilities.
Quantitative Easing as a Monetary Tool
Participants generally supported the purchases of agency debt and agency mortgage-backed securities (MBS) that were announced a few weeks before the meeting. Many, but not all, participants agreed that purchases of long-term securities could lower long-term interest rates. There was disagreement over the relative merits of purchasing Treasury securities or MBS. Some argued that MBS purchases distort the allocation of credit in the economy, but others saw the extra effect of MBS purchases on mortgage rates as a benefit. Most participants felt that the FOMC was likely to begin to purchase longer-term Treasury securities within the next two meetings, and a sentence confirming this possibility was included in the statement.
The background memos on this topic argued that purchases of long-term assets could lower long-term interest rates, but that the effects were small and subject to considerable uncertainty because there was little prior analysis on which to rely. Each $50 billion of purchases of long-term Treasuries was judged to lower the 10-year Treasury yield 2 to 10 basis points. Subsequent research has found results remarkably consistent with this range.
The FOMC began Treasury purchases and increased MBS purchases in March 2009. Since then, quantitative easing has proved to be the primary tool the Fed uses when it feels the economy needs more speed, with communication about future policy a secondary and complementary instrument.
