Measuring money... faster, cheaper, cleaner

A recent research publication entitled, "The Fed's Exit Strategy for Monetary Policy," written by Glenn Rudebusch, senior V.P. and associate director of research at the Federal Reserve Bank of San Francisco, posits that it may 2012 before the Federal Reserve begins hiking interest rates. The introduction says, "As the financial crisis has receded, the Federal Reserve has scaled back its extraordinary provision of liquidity. Eventually, the Fed will remove all remaining monetary stimulus by raising the federal funds rate and shrinking its balance sheet. The timing of such renormalizations depends crucially on evolving economic conditions."

Rudebusch writes, "To many observers, the Federal Reserve's extraordinary policy actions during the recent crisis averted a financial Armageddon and curtailed the depth and duration of the recession (Rudebusch 2009). To combat panic and dislocation in financial markets, the Fed provided an enormous amount of liquidity. To mitigate declines in spending and employment, it reduced the federal funds interest rate -- its usual policy instrument -- essentially to its lower bound of zero. To provide additional monetary stimulus, the Fed turned to an unconventional policy tool -- purchases of longer-term securities -- which led to an enormous expansion of its balance sheet."

He continues, "As financial market strains eased and economic recovery began, discussion turned to how the Fed would unwind its actions (Bernanke 2010). Of course, after every recession, the Fed has to decide how quickly to return monetary conditions to normal to forestall inflationary pressures. This time, however, policy renormalization is especially challenging because of the unprecedented economic conditions and Fed actions. This Economic Letter describes various considerations in formulating an appropriate policy exit strategy. Such a strategy must unwind each of the Fed's three key actions: the establishment of special liquidity facilities, the lowering of short-term interest rates, and the increase in the Fed's securities holdings."

The paper explains, "Starting in August 2007, money markets experienced periods of dysfunction with sharply higher short-term interest rates for commercial paper and interbank borrowing. This intense liquidity squeeze, in which even solvent borrowers found it difficult to secure essential short-term funding, appeared likely to have severe financial and economic repercussions. Therefore, the Fed, acting in its traditional role as liquidity provider of last resort, introduced a variety of special facilities to supply funds to banks and the broader financial system."

It says, "By the end of 2008, the Fed was providing over $1 1/2 trillion of liquidity through short-term collateralized credit. Generally, this liquidity was designed to cost more than private credit when financial markets were functioning normally. Therefore, as financial conditions improved during 2009, borrowers switched to private financing. By early 2010, demand had dried up for the Fed's special facilities and they were closed. The facilities incurred no credit losses and provided a sizable return of interest income to taxpayers. More importantly, the liquidity facilities helped limit a pernicious financial and economic crisis (Christensen, Lopez, and Rudebusch 2009)."

The FRBSF work explains, "Figure 1 also provides a simple perspective on when the Fed should raise the funds rate. The dashed line combines the benchmark rule of thumb with the Federal Open Market Committee's median economic forecasts (FOMC 2010), which predict slowly falling unemployment and continued low inflation. The dashed line shows that to deliver future monetary stimulus consistent with the past -- and ignoring the zero lower bound -- the funds rate would be negative until late 2012. In practice, this suggests little need to raise the funds rate target above its zero lower bound anytime soon. This implication is consistent with the Fed's forward-looking policy guidance (FOMC 2010) that 'economic conditions -- including low rates of resource utilization, subdued inflation trends, and stable inflation expectations -- are likely to warrant exceptionally low levels of the federal funds rate for an extended period.' This guidance indicates that the length of the 'extended period' depends on the expected path of unemployment and inflation. Similarly, the benchmark policy rule would prescribe an earlier or later increase in the funds rate if unemployment or inflation rose or fell more rapidly than predicted in the forecasts underlying Figure 1."

But it says, "In contrast, some have argued that holding short-term interest rates near zero for much longer could foster dangerous financial imbalances, such as asset price misalignments, bubbles, or excessive leverage and speculation (see FOMC 2010). The risk of such financial side effects could shorten the appropriate length of a near-zero funds rate. However, the linkage between the level of short-term interest rates and the extent of financial imbalances is quite erratic and poorly understood. For example, during the past decade and a half, Japanese short-term interest rates have been essentially at zero with no sign of building financial imbalances. Therefore, some remain skeptical that monetary policy should directly aim to restrain excessive financial speculation, especially while prudential financial regulation remains available for this task (Kohn 2010)."

Finally, the piece concludes, "Many predict that the economy will take years to return to full employment and that inflation will remain very low. If so, it seems likely that the Fed's exit from the current accommodative stance of monetary policy will take a significant period of time."

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