By Steven K. Beckner
WASHINGTON (MNI) – San Francisco Federal Reserve Bank President
John Williams said Friday that the Fed has a proven ability to lower
long-term interest rates through large-scale asset purchases,
but said the economic impact of those purchases is uncertain.
Williams said the $400 billion “maturity extension program”
launched Wednesday by the Fed’s policymaking Federal Open Market
Committee — better known as “Operation Twist” — will have to be
evaluated in terms of two different channels in which so-called LSAPs
work.
Williams, who will be a voting member of the FOMC in 2012, defended
the FOMC’s previous policy action — an extension of the zero federal
funds rate policy “through at least mid-2013,” saying that such “forward
guidance” proved its effectiveness in the face of the zero rate bound by
pushing market interest rates lower.
The other tool for easing policy in the face of the zero bound is
LSAPs, whether financed by new money creation (“quantitative easing’) or
by sales of short-term assets (“twist”). But Williams acknowledged there
are uncertainties and potential problems.
For example, he said LSAPs can lead to distortions in financial
markets and asset prices. And he said that the public remains
“unfamiliar” with unconventional policymaking, which can cause
uncertainty.
Williams did not talk about what more the Committee might do in
academically styled remarks prepared for delivery to a Swiss National
Bank research conference in Zurich.
“Forward policy guidance” — a central bank pre-committing to a
future path of short-term interest rates — can theoretically
“circumvent the effects of the zero lower bound,” he said, because
making such a future committment can control longer-term interest rates
by “managing expectations” about the future path of short-term rates.”
“In theory, forward guidance about the future path of policy is a
potentially powerful tool that can almost completely solve a central
bank’s problems at the zero lower bound,” Williams said, but he added
that “there are reasons to be skeptical that forward guidance would be
such a panacea in practice.”
“For this policy to have the desired effects, the central bank
must commit to two things: keeping the short-term policy rate lower than
it otherwise would in the future, and allowing inflation to rise higher
than it otherwise would,” he explained. “However, when the time comes
for the central bank to fulfill this commitment, it may not want to do
so.”
The central bank “might find it hard to resist the temptation to
raise rates earlier than promised to avoid the rise in inflation,” he
continued. “Indeed, policymakers have generally shied away from policies
that promise temporarily high inflation in the future, such as price
level targeting, that are in theory effective at circumventing the zero
bound. This reluctance arises in part out of a concern that such an
approach could unmoor inflation expectations.”
Williams added a second caveat — that “the public may have
different expectations of the future course of the economy and monetary
policy than the central bank. … If the public has an imperfect
understanding of the central bank’s intended policy path, then forward
guidance may not work as well as advertised.”
So he said “a key challenge for forward guidance is communicating
the intended policy path to the public.”
“Complicating this communication challenge further, optimal forward
guidance is inherently state-contingent and depends on myriad factors
and risk assessments. These are inherently difficult to convey to the
public,” he said. “Moreover, the public and the media tend to gloss over
such nuances and take away simple sound bites.”
Having issued those caveats, though, Williams noted that the Fed’s
latest “forward guidance” had the effect of lowering two-year Treasury
yields by about 10 basis points and 10-year Treasury yields fell by
about 20 basis points following the Aug. 9 announcement.”
“This provides prima facie evidence of the powerful effects of
forward guidance at the zero bound,” he said.
As for the other major unconventional tool, Williams said many
studies have shown that LSAPs reduce long-term rates by 15 to 20 basis
points. “Keep in mind that the typical response of the 10-year
Treasury yield to a 75 basis point cut in the federal funds rate is also
about 15 to 20 basis points,” he remarked. “I’ve never heard anyone
argue that a 75 basis point cut in the funds rate is small potatoes!”
Williams said some of the impact of LSAPs comes from a “signaling”
effect — how the announcement of asset purchases affect public
expectations of future short-term interest rates. But LSAPs can also
work through a “portfolio channel” as they affect yields.
“The evidence is far from conclusive, but it does tentatively
support some role for the portfolio channel,” he said. “First, by some
measures, expected short rates fell by less than government securities
of equivalent maturity. Second, there is some evidence in the literature
that the pass-through from purchases of Treasury securities to private
borrowing rates, such as corporate bond rates, may be relatively
low.”
Williams said there is “uncertainty regarding how the portfolio
channel actually works.”
“In particular, to what extent is it the size or the composition of
the central bank’s balance sheet that matters?” he asked. “This question
is no mere theoretical curiosity, but has very real practical
relevance.”
“For example, it is critical for gauging the efficacy of a maturity
extension program that lengthens the maturity of securities holding with
no change in the quantity of holdings, such as the policy announced
earlier this week by the FOMC,” he went on. “This program contrasts with
a policy that simply increases the holdings of Treasury securities, such
as the Fed’s second asset purchase program initiated late last year.”
Williams said “the size-versus-composition question bears directly
on the relative effectiveness of the two policy variants. In addition,
the question is relevant for comparing the effects of a policy of
purchasing Treasury securities with one of buying mortgage-backed
securities.”
Raising other issues for future research, Williams asked, “should
unconventional policies be a regular part of our toolkit or should they
be reserved only for extraordinary times? That is, should forward
guidance and LSAPs complement standard short-rate policies at all times
or only at the zero lower bound?”
He raised potential problems. “These policies are still relatively
unfamiliar to the public. Consequently, their effects on the public’s
inflation expectations, appetite for risk, and so forth are difficult to
predict. This adds an element of uncertainty and raises concern about
unintended consequences.”
“In addition, LSAPs may create distortions to asset prices or
financial market functioning,” he said. “These costs must be
weighed against the value of asset purchases for macroeconomic
stabilization.”
And Williams asked, “how do these policies change our thinking
about the optimal rate of inflation?”
“In particular, if unconventional monetary policies can
effectively circumvent the zero lower bound, then there is less of a
need for an inflation cushion,” he said. “But, if these policies cannot
in practice be used as substitutes for reducing the short-term rate,
then there is greater need for an inflation cushion.”
** Market News International Washington Bureau: 202-371-2121 **
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