During the onset of a very severe financial and economic crisis in 2008, the federal funds rate reached the zero lower bound (ZLB). With this primary monetary policy tool therefore rendered ineffective, in November 2008 the Federal Reserve started to use its balance sheet as an alternative policy tool when it began the large-scale asset purchases. Now attention is turning to how the Fed should transition back to a more conventional monetary policy stance. Largely missing from these discussions about the Fed’s “exit strategy” is a consideration that perhaps it should retain, not discard, the balance sheet tools. Since the Dodd-Frank Act (DFA) has added maintaining financial stability to the Fed’s existing dual mandate to achieve maximum sustainable employment in the context of price stability, it might be beneficial to have several tools to achieve multiple policy objectives. An additional consideration is that some of these tools may be needed to stem future crises as a result of the DFA’s new limitations on how the Fed can provide liquidity under such adverse circumstances. In an effort to spur a broader debate, this brief discusses what is known and knowable regarding the effectiveness of balance sheet tools and examines four primary arguments for keeping these as part of the Fed’s toolkit.
Key Findings
The relative costs and benefits of conventional versus unconventional policy are difficult to know, so appeals to these types of arguments in favor of one type of policy tool are hard to support. In terms of the absolute costs of balance sheet tools, there was a fear that using such tools would engender high inflation or unanchored inflation expectations. Yet after six years, neither result has occurred.
Having more than just one primary policy tool confers greater flexibility and may allow the Fed to better fulfill what are now its three policy goals. Moreover, using balance sheet tools to specifically target the sector(s) that are in disequilibrium would let the Fed better focus its policy efforts on the sectors it wants to affect and would diminish some of the potential policy tradeoffs that arise when just one policy instrument is available. Such arguments become even more powerful when the simultaneous objective of ensuring financial stability must be met.
In a low inflation environment, the probable frequency and duration of hitting the ZLB may actually be much greater than previously appreciated, and hence the need for having alternative policy instruments may be more critical than before.
With the ability to operate more directly on the asset classes and interest rates it would like to see changed, the Fed may be able to better communicate its policy intentions to market participants.
This is the kind of research than can fast track a career. In reality it’s miles behind the curve. A quick glance at Japan can tell you that. But by framing the discussion using today’s conventional assumptions it turns what is a near certainty for the future into a act of prescience.
This is one reason why MB has been so hard on Australian regulator’s refusal to innovate their own monetary policy tools. QE is here to stay and they have no way of dealing with it.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
