A Dummy’s Guide to Unconventional Monetary Policy

Yup.  The Richmond Fed has taken the time to climb down and talk in layman’s terms about its quantitative easing and its other “unconventional” policies that have saved the day for the USA.  As an example:

This unusual situation is called the “zero lower bound” (ZLB) on nominal interest rates.2 Once the Fed confronted the ZLB, it turned to alternative tools to ease monetary policy further. These unconventional monetary policy tools fall into three general areas: increasing the size of the Fed’s balance sheet; altering the composition of its balance sheet; and providing increasingly detailed guidance about the likely future path of policy.

Exerpts from the essay:

This unusual situation is called the “zero lower bound” (ZLB) on nominal interest rates.2 Once the Fed confronted the ZLB, it turned to alternative tools to ease monetary policy further. These unconventional monetary policy tools fall into three general areas: increasing the size of the Fed’s balance sheet; altering the composition of its balance sheet; and providing increasingly detailed guidance about the likely future path of policy.

Before discussing the new tools further, it is important to note that the Fed’s objectives have not changed. The Fed is bound by the congressionally established mandate to promote both maximum sustainable employment and price stability, together referred to as the “dual mandate.”

In normal times—that is, when the Fed is not facing the ZLB on nominal interest rates—the Fed loosens monetary policy by reducing the federal funds target rate and the primary credit rate (better known as the discount rate). These actions tend to translate into lower interest rates elsewhere in the economy. The announcement of a lower target rate is accompanied by a commitment to perform whatever open market asset purchases might be necessary to ensure that the actual federal funds rate falls along with the target rate.

Asset purchases expand the Fed’s balance sheet and inject funds into the banking system. Though today the ZLB means the central bank cannot push its policy interest rate lower, the Fed still can purchase assets in an attempt to infl uence broader market interest rates. Accordingly, the fi rst unconventional monetary policy move of the past several years has been to make large-scale asset purchases (LSAPs), often called “quantitative easing” (QE).4 This has occurred in three rounds:

• From November 2008 through March 2010, the Fed purchased $1.75 trillion in long-term Treasuries as well as debt issued by Fannie Mae and Freddie Mac and fi xed-rate mortgagebacked securities (MBS) guaranteed by those agencies. (This fi rst round has been called QE1.)
• From November 2010 through June 2011, the Fed purchased $600 billion in long-term Treasuries (QE2).
• And in September 2012, the Fed announced that it would purchase $40 billion in agency-backed MBS per month until economic conditions improved substantially (QE3).

These LSAPs have expanded the Fed’s balance sheet signifi cantly. As noted, the purpose of LSAPs is to put downward pressure on overall market interest rates. LSAPs can lower market interest rates through two channels.5 The fi rst is the portfolio rebalance channel. Many investors are not indifferent between holding diff erent types of long-term assets. For example, they may be restricted by regulations from holding certain assets, or they may have preferences for assets with certain risk characteristics.

Because assets are not perfectly substitutable, and LSAPS change the relative supply of assets available to investors to purchase, LSAPs have the potential to change asset prices and interest rates. The second way LSAPs could lower market interest rates is by signaling that the Fed is likely to keep its policy rate low for a longer period than previously believed. The Fed’s willingness to engage in LSAPs could have this signaling eff ect if they provide new information about the economic forecast or about how stimulative the Fed is willing to be.

Additionally, exiting from the LSAP policy quickly would require significant asset sales that could disrupt markets. In contrast, a slow exit would be accomplished by simply waiting for the assets to mature and roll off the Fed’s balance sheet. Therefore, if market participants expect the Fed to begin reducing the size of its balance sheet before raising rates, then larger LSAPs could signal that rates are likely to stay low for a longer time.

In fact, one danger posed by LSAPs is that they may exacerbate the risk associated with the Fed “getting behind the curve” in raising interest rates as the economy strengthens. LSAPs have signifi cantly increased the amount of excess reserves in the banking system. In the fi ve years prior to late 2008, excess reserves ranged between 1 percent and 20 percent of total reserves; today, 94 percent of reserves are excess reserves. Large excess reserves can lead to inflation if banks use those reserves to fund lending, thereby increasing the money supply. This has not occurred thus far, and the Fed has tools to prevent it.

Read the complete essay at the Richmond Fed.