Lessons at the Zero Bound

May 21, 2013

William C. Dudley
, President and Chief Executive Officer, the Federal Reserve Bank of New York

Shinya Wako
, Managing Executive Officer & Head of the Americas, Mizuho Corporate Bank, Ltd.; Member, Board of Directors of Japan Society

On May 21, 2013, William Dudley, President and CEO of the Federal Reserve Bank of New York, spoke at Japan Society about doing monetary policy at the zero bound, when an economy is in trouble but interest rates are already so low that they can't be lowered further.

"As always, what I have to say today represents my own views and not necessarily those of the Federal Open Market Committee or the Federal Reserve System," Mr. Dudley reminded the audience.

Six Key Lessons for Central Banks
"Until Japan's experience began in the 1990s, no major country had actually faced this problem since the Great Depression of the 1930s," he said. "As the first nation to experience a zero bound in modern times, Japan was an early pioneer in developing unconventional tools and strategies."

Out of Japan's experiences, together with the experiences of the Great Depression and other crucial periods, we can draw six key lessons for central banks, he said:

1. Manage expectations, both as to the central bank's goals and as to how the central bank will use its tools to reach those goals.

Just as expectations of inflation "are an important driver of actual inflation outcomes, deflationary expectations can be self-fulfilling in driving actual deflation outcomes," he said.

At the zero bound, the "expectations channel," through which the central bank talks about its policy rate and balance sheet goals—is "the predominant vehicle by which the central bank's actions affect financial market conditions. If this expectations channel did not work, then it would be very difficult to provide additional monetary policy accommodation."

2. Communicate those expectations clearly, coherently and consistent with the bank's guidance.

"Expectations about how policy will respond can be an important self-stabilizing element of monetary policy. In this regard a framework that ties the use of the policy tools explicitly to economic outcomes has many advantages," Mr. Dudley said.

3. Action speaks louder than words alone, and thus asset purchases play an important role.

"Taking interest rate risk and mortgage pre-payment risk out of private hands has proven to be effective in easing financial conditions, increasing wealth and lowering private sector borrowing cost"; and the impact of asset purchases "does build over time."

4. Policy instruments interact, so the policy as a whole exceeds the sum of its parts.

"The policy rate, the balance sheet expectations about the future stance, the degree of commitment on future policy, the clarity of communications," all are interrelated and work together.

5. Be alert to issues of risk management, given the great costs of getting stuck in a liquidity trap with chronic deflation.

Again, "at the zero lower bound once you're caught in deflation, it's very hard to get out. Thus, policymakers need to put considerable weight on this risk, and conduct monetary policy with sufficient aggressiveness to ensure that they can avoid such an outcome."

6. Understand that monetary policy can't do it all, but needs to be matched with "credible fiscal policies, actions to ensure a healthy financial system, and structural reforms that lift the potential for growth."

Nonconventional tools have costs; with large-scale asset purchases, for example, there are "potential cost increases in terms of market functioning, the risk to financial stability, and the path of future remittances from the Federal Reserve to the U.S. Treasury."

Long-term budgets need to be "credible and consistent with fiscal sustainability." It's also important to remove structural impediments to growth, which in the case of the U.S. "could include changes in immigration policy, infrastructure investments that remove bottlenecks and job-training programs that improve the quality of human capital."

Overview of Japan's Experiences
With the bursting of Japan's bubble in equities and real estate in the early 1990s, the BOJ cut interest rates "from a peak of more than 8 percent in early 1991 to half a percent by the fall of 1995. Most studies of this period suggest that policy was generally appropriate given economic forecasts at the time, but too tight relative to actual outcomes," Mr. Dudley said.

"It's noteworthy to me that as late as January 1995—on the eve of deflation—10-year JGB yields were still at 4.7 percent. With a bit of hindsight we now understand that the disinflationary consequences of the asset price bust and financial stress were vastly more powerful than was widely realized at the time."

"As we later saw in the United States, the forces of contraction and deflation operated through many different channels; not just directly on household wealth, for example, but also through the impact of the asset price bust, and the health of financial intermediaries, and the supply of credit to households and businesses."

The BOJ's innovative techniques for dealing with these issues included:
● Forward guidance on the future path of the policy rate
● Quantitative easing through the purchases of government securities and private assets, including asset-back securities, equities and real estate investment trusts
● A more quantitative inflation objective
● A funding for bank lending programs

"From my perspective, Japan’s experience with forward guidance for the policy rate, asset purchases, and a more formal inflation goal are particularly instructive," Mr. Dudley commented.

The BOJ's QE program launched in 2001 involved mainly the purchase of short-dated JGBs. One advantage was that when the economy started moving again and the Bank halted its QE purchases, these assets would mature in short order, after which the Bank's balance sheet would be back to normal.

A disadvantage, however, is that the private sector was exchanging one short-term risk-free asset, short-dated JGBs, for another, bank reserves. Thus "the purchases had only modest direct effects on financial conditions."

Overview of U.S. Experiences
"Japan's experience reinforced the lessons of the Great Depression here in the United States, and made us sensitive to the disinflationary force of an asset price bust and financial crisis," he said.

As the U.S. housing market collapsed starting in 2007 with the subprime mortgage crisis, the Fed cut short-term rates to nearly zero by late 2008.

"Immediately upon reaching the zero bound for interest rates, we provided additional stimulus by expanding our balance sheet and deploying forward guidance with respect to the policy rate," Mr. Dudley said. "These actions, in the context of a strong commitment to both our inflation and employment mandates, succeeded in preventing deflation expectations from taking hold even though outcomes for the real economy were disappointing. We also took steps to formalize that we had a 2 percent inflation objective."

The Fed concentrated its asset purchases in longer-term Treasuries and agency MBS, thus working "primarily through the asset side of the central bank’s balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet."

Risk premia and interest rates were pushed downwards, prompting private sector investors to invest in riskier asset types. "As a result, financial conditions become easier, and this supports wealth and aggregate demand."

Mr. Dudley noted that "the fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct of our actions, but it’s incidental. It’s not a goal of our quantitative easing programs."

Recapitalizing the banks was of great importance given the capital-markets-based nature of the U.S. financial system, he added.

"All that said, though, our policy approach was far from perfect," with FOMC participants' quarterly growth projections "consistently too optimistic" versus actual growth numbers in the period 2009-2012.

"As a result, with the benefit of hindsight, we did not provide enough stimulus. Perhaps if we had paid more attention to the persistent divergence between the growth forecast and actual outturns in Japan in the 1990s, we might have been more skeptical about the prospects for a strong economic recovery here in the U.S. even with a more aggressive monetary policy regime in place."

"Also, we could have done a better job in communicating our intentions and goals. My opinion is that we put too much emphasis too early on exit. At an earlier stage we should have put more emphasis on our commitment to use all our tools to the fullest extent possible for as long as needed to achieve our dual mandate objectives."

Convergence of Policies in Japan & the U.S.
Japan and the U.S. have converged in a number of important respects in their handling of monetary policy, Mr. Dudley said.

"Both the Fed and the Bank of Japan place considerable emphasis on an explicit inflation objective. Both commit the central bank to use all available tools to achieve its objectives, and use forward guidance on interest rates, and large-scale purchases of long-duration assets as the main tools to achieve these objectives."

Differences that remain are matters of "legal framework and the current starting point for economic activity and inflation rather than reflecting fundamental differences in philosophy."

Implications for Future U.S. Monetary Policy
Turning to future policy, Mr. Dudley said that in his view the base case forecast for the labor market and inflation "should not be the sole consideration. We also have to look at how confident we are of that outcome actually occurring."

"Because the outlook is uncertain, I can’t be sure today which way up or down the next change will be, but at some point I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we were adding accommodation through asset purchases."

The exit principles that the Fed set out in June 2011 "seem stale to me in several respects," he added The Fed is now using economic thresholds—thresholds, not triggers—instead of date-based guidance. With a lot more agency MBS on the Fed's balance sheet now than in June 2011, the FOMC "could decide to indicate that it will avoid selling mortgage-backed securities during the early stages of the normalization process," or indeed to "allow agency MBS securities to run off passively over time."

"There is a risk that market participants could overreact to any move in the process of normalization." The core principle is "our unbending commitment to our dual-mandate objectives of maximum sustainable employment in the context of price stability," he concluded.


Shinya Wako of Mizuho Corporate Bank, who presided, began the Q&A:

When the Fed adopted a zero interest policy in 2008, how did you evaluate Japan's experience during the 1990s, when there was a zero interest policy in place but it didn't lead to a robust economic recovery?

"We felt that, at least speaking for myself at the FOMC, that it was important to learn the lesson that you probably need to do more than you think you need to do, because the downward forces of deflation and economic contraction when asset booms go bust are very, very powerful."

"We were lucky in two respects," Mr. Dudley reflected. One, whereas "Japan really didn't have anybody to learn from," the FOMC was able to learn from Japan's experiences. And two, "we have a capital-based financial system here, and a capital-based financial system deals out pain in real time—very intense pain. And it really basically forced us to deal with our major financial institutions in 2008 and 2009."

"And even today credit availability is not back to where we would probably like to see it be over the medium to longer term."

Audience members joined in the dialogue:

Business people I talk to express some level of concern about the magnitude of the Fed actions in their own investment decisions. How does the Fed weigh this?

"I think one thing that we’re always trying to do is explain how our policy is going to work, and that the risk of an expanded balance sheet does not pose any risks of future inflation," Mr. Dudley said.

"We have the tools in place to manage monetary policy effectively even with a balance sheet much larger than the balance sheet that we have today," notably "the ability to pay interest on excess reserves," which the Fed was given in fall 2008.

"In my opinion, that tool alone is fully effective in terms of being able to conduct monetary in a way so that we will not have a future inflation problem."

"We have to communicate that to people, because a lot of people read the old money and banking textbooks. MV=PQ—money times velocity equals price times quantity. They say, 'Gee, the monetary base has gone up a lot, and so that’s going to lead to future inflation.' The reality is we now have a tool to cut that link—the ability to raise the interest rate on excess reserves, which will keep the reserves in the banking system rather than lent out if we ever get to that point."

How would you rate the BOJ's performance?

"Central bankers never judge other central bankers," Mr. Dudley said with amusement. He went on: "I think what they’re doing makes complete sense. I think based on what has happened over the last few months, I would say that policy is working quite effectively. I think the big question that market participants around the world have is what’s the third arrow of Prime Minister Abe going to look like in terms of structural reform. So, what has been done to date has been very, very good, but the course isn’t finished."

U.S. inflation rates have fallen pretty sharply for I’d say not fully explained reasons recently. Is this a concern for policy?

"First of all, I would say it has gotten our attention."

"Speaking for myself, I’m not yet at the point where I’m really concerned about it," he added. There are some technical aspects that are probably pushing down the rate, "but, more importantly than that technical issue, is the fact that inflation expectations haven’t moved down."

Now that the economy has been recovering, albeit slowly, the labor market has been improving. Is it too soon to talk about exit? What gives you enough confidence to start to think about talking about exit?

"It's definitely a tricky subject," Mr. Dudley acknowledged. "We really want to achieve sort of an escape velocity for the economy so that the economy has got a self-generating economic recovery—jobs beget income, beget spending, beget jobs. Once we have that sort of self-reinforcing dynamic in the economy and we’re confident about that, then I think it’s really time to put more attention on—I’m using the term normalizing policy. Notice I didn’t use that word in my speech. I’m trying to talk about it in a somewhat different way. That’s deliberate."

—Katherine Hyde

Topics:  Business, Policy

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