One of the biggest questions regarding Federal Reserve monetary policy strategy was answered at Jackson Hole… Last year.
At this year’s Economic Policy Symposium in Jackson Hole, Janet Yellen stuck with the script that she and the Fed board has maintained all along – that monetary policy will stay the course until labor market conditions have shown a fundamental improvement. Even though hiring is up, wages are still stagnant, and there still remains significantly slack in the labor force – especially as measured by the growing gap between the percentage of workers who are working part-time for economic reasons (which has hardly fallen) and the unemployment rate (which has fallen precipitously).
As Yellen remarked, “a key challenge is to assess just how far the economy now stands from attainment of its maximum employment goal.” And by her vast set of metrics, that is still quite a long way away.
Last year, with Ben Bernanke at the helm of the Federal Reserve, there was a lot more discussion over other peripheral issues, aside from labor market dynamics. For example, a paper was presented by economists Arvind Krishnamurthy and Annette Vissing-Jorgensen. It was – and remains – the best paper on how the Federal Reserve plans on resuming a normal course of monetary policy after the massive asset purchase programs end.
With this third round of quantitative easing, the Federal Reserve’s balance sheet has continued to grow – albeit at a slower pace in recent months.
What to do with those assets was a central theme at LAST YEAR’S Jackson Hole symposium
The essential decision that will have to be made is how to unwind the Fed’s balance sheet. As Krishnamurthy and Vissing-Jorgensen wrote,
We then consider the effects of the exit from the Treasury bond QE. We argue that a sale or cessation of Treasury bond purchases will have minimal negative effects. While it will raise the rates on long-term Treasury bonds and affect financing conditions for the US government, it will have limited negative consequences to private borrowers. This result is a corollary to our finding that the Treasury purchases themselves have had limited beneficial spillovers to private borrowers.
From this analysis of the mechanics of LSAPs, we conclude that an exit should proceed in the following sequence: The Fed should first cease its purchases of Treasury bonds and then sell down its Treasury portfolio. Second, the Fed should sell its higher-coupon MBS as this will have small effects on primary market mortgage rates. The last step in this sequence is that the Fed should cease its purchases of current-coupon MBS as this tool is currently the most beneficial source of economic stimulus.
Just letting the balance sheet draw down by letting dated bonds expire still remains the most popular prognostication. It is certainly the least disruptive and safest option.
However, it seems that Janet Yellen is not the least bit concerned about what to do with the Fed’s asset base in a number of years – she wants to fix the employment situation now, and it seems like she is willing to keep rates at the absolute minimum until that happens. In fact, some argue that more aggressive policies are needed.
Larry Summers has recently hypothesized that “secular stagnation” is already entreanched in the economy, and that monetary policy as is cannot achieve full employment or for the economy to reach its potential output without significant risk of financial instability. Instead, Summers argues that the appropriate policy mix…
“…should include increased public investment, reductions in structural barriers to private investment and measures to promote business confidence, a commitment to maintain basic social protections so as to maintain spending power, and measures to reduce inequality and so redistribute income towards those with a higher propensity to spend.”