BOSTON (MNI) – The following is the third section of the remarks
of Federal Reserve Vice Chair Janet Yellen prepared Wednesday for the
Boston Economic Club:

In response to the evolving outlook, the FOMC has progressively
added policy accommodation using both of its unconventional tools. For
example, since the federal funds rate target was brought down to a range
of 0 to 1/4 percent in December 2008, the FOMC has gradually adjusted
its forward guidance about the anticipated future path of the federal
funds rate. In each meeting statement from March 2009 through June 2011,
the Committee indicated its expectation that economic conditions gare
likely to warrant exceptionally low levels of the federal funds rate for
an extended period. At the August 2011 meeting, the Committee decided to
provide more specific information about the likely time horizon by
substituting the phrase gat least through mid-2013h for the phrase
gfor an extended periodh; at the January 2012 meeting, this horizon
was extended to gat least through late 2014.h9 Has this guidance
worked? Figure 7 illustrates how dramatically forecastersf expectations
of future short-term interest rates have changed. As the dashed blue
line indicates, the Blue Chip consensus forecast made in early 2010
anticipated that the Treasury-bill rate would now stand at close to
3-1/2 percent; today, in contrast, private forecasters expect short-term
interest rates to remain very low in 2014. Of course, much of this
revision in interest rate projections would likely have occurred in the
absence of explicit forward guidance; given the deterioration in
projections of real activity due to the unanticipated persistence of
headwinds, and the continued subdued outlook for inflation, forecasters
would naturally have anticipated a greater need for the FOMC to provide
continued monetary accommodation. However, I believe the changes over
time in the language of the FOMC statement, coupled with information
provided by Chairman Bernanke and others in speeches and congressional
testimony, helped the public understand better the Committeefs likely
policy response given the slower-than-expected economic recovery. As a
result, forecasters and market participants appear to have marked down
their expectations for future short-term interest rates by more than
they otherwise would have, thereby putting additional downward pressure
on long-term interest rates, improving broader financial conditions, and
lending support to aggregate demand.

The FOMC has also provided further monetary accommodation over time
by altering the size and composition of the Federal Reservefs
securities holdings, shown in figure 8. The expansion in the volume of
securities held by the Federal Reserve is shown in the left panel of the
figure. During 2009 and early 2010, the Federal Reserve purchased about
$1.4 trillion in agency mortgage-backed securities and agency debt
securities and about $300 billion in longerterm Treasury securities. In
November 2010, the Committee initiated an additional $600 billion in
purchases of longer-term Treasury securities, which were completed at
the end of June of last year. Last September, the FOMC decided to
implement the gMaturity Extension Program,h which affected the
maturity composition of our Treasury holdings as shown in the right
panel. Through this program, the FOMC is extending the average maturity
of its securities holdings by selling $400 billion of Treasury
securities with remaining maturities of 3 years or less and purchasing
an equivalent amount of Treasury securities with remaining maturities of
6 to 30 years. These transactions are currently scheduled to be
completed at the end of this month. Research by Federal Reserve staff
and others suggests that our balance sheet operations have had
substantial effects on longer-term Treasury yields, principally by
reducing term premiums on longer-dated Treasury securities. Figure 9
provides an estimate, based on Federal Reserve Board staff calculations,
of the cumulative reduction of the term premium on 10-year Treasury
securities from the three balance sheet programs. These results suggest
that our portfolio actions are currently keeping 10-year Treasury yields
roughly 60 basis points lower than they otherwise would be. Other
evidence suggests that this downward pressure has had favorable
spillover effects on other financial markets, leading to lower long-term
borrowing costs for households and firms, higher equity valuations, and
other improvements in financial conditions that in turn have supported
consumption, investment, and net exports. Because the term premium
effect depends on both the Federal Reservefs current and expected
future asset holdings, most of this effect — without further actions —
will likely wane over the next few years as the effect depends less and
less on the current elevated level of the balance sheet and increasingly
on the level of holdings during and after the normalization of our
portfolio.

The Rationale for Highly Accommodative Policy

I have already noted that, in my view, an extended period of highly
accommodative policy is necessary to combat the persistent headwinds to
recovery. I will next explain how Ifve reached this policy judgment. In
evaluating the stance of policy, I find the prescriptions from simple
policy rules a logical starting point. A wide range of such rules has
been examined in the academic literature, the most famous of which is
that proposed by John Taylor in his 1993 study. Rules of the general
sort proposed by Taylor (1993) capture well our statutory mandate to
promote maximum employment and price stability by prescribing that the
federal funds rate should respond to the deviation of inflation from its
longer-run goal and to the output gap, given that the economy should be
at or close to full employment when the output gap–the difference
between actual GDP and an estimate of potential output–is closed.
Moreover, research suggests that such simple rules can be reasonably
robust to uncertainty about the true structure of the economy, as they
perform well in a variety of models.14 Today, I will consider the
prescriptions of two such benchmark rules–Taylorfs 1993 rule, and a
variant that is twice as responsive to economic slack. In my view, this
latter rule is more consistent with the FOMCfs commitment to follow a
balanced approach to promoting our dual mandate, and so I will refer to
it as the gbalanced-approachh rule.

To show the prescriptions these rules would have called for at the
April FOMC meeting, I start with an illustrative baseline outlook
constructed using the projections for unemployment, inflation, and the
federal funds rate that FOMC participants reported in April.16 I then
employ the dynamics of one of the Federal Reservefs economic models,
the FRB/US model, to solve for the joint paths of these three variables
if the short-term interest rate had instead been set according to the
Taylor (1993) rule or the balanced-approach rule, subject, in both
cases, to the zero lower bound constraint on the federal funds rate. The
dashed red line in figure 10 shows the resulting path for the federal
funds rate under Taylor (1993) and the solid blue line with open circles
illustrates the corresponding path using the balanced-approach rule.17
In both simulations, the private sector fully understands that monetary
policy follows the particular rule in force.18 Figure 10 shows that the
Taylor rule calls for monetary policy to tighten immediately, while the
balanced-approach rule prescribes raising the federal funds rate in the
fourth quarter of 2014–the earliest date consistent with the FOMCfs
current forward guidance of gexceptionally low levels for the federal
funds rate at least through late 2014.

-more- (3 of 4)

** MNI **

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