THE BASIS POINT

San Francisco Fed President Janet Yellen’s Take On Fed Policy, Economy

 

In a speech yesterday, San Francisco Fed president discussed the economy and the government responses. The speech was called The Outlook For 2009, but mostly it was a review and defense of what the Fed (and some of what the Treasury) is doing.

Summary current economic situation: Note this is just a summary of the consumer. The full report, linked above, discusses the follow areas of the economy: business, non-residential construction, mortgages—including the non-existence of the private mortgage securities market, declines in home prices, state and local governments, and non-US economic weakness.

Economic weakness is evident in every sector of the economy. After declining slightly in the third quarter, real personal consumption expenditures appear to have fallen more sharply in the fourth. Such retrenchment in consumer spending is understandable, given the truly tough conditions that households face, but especially troubling because this sector represents over 70 percent of GDP. With respect to jobs, employment has declined for twelve months in a row, and the unemployment rate now stands at 7¼ percent up from 5 percent just a year ago. With respect to wealth, the combined impact of falling equity and house prices has been staggering. Household wealth has declined by an estimated $10 trillion. With respect to consumer credit, it is both costlier and harder to get. Not surprisingly, consumer confidence is at a 30-year low and the personal saving rate is on the rise, as people try to rebuild their wealth and provide a cushion against the possibility of job loss. The recent plunge in vehicle sales, in spite of lower gas prices and huge price incentives, reflects this lack of confidence as well as the difficulties people are having in getting auto loans.

Summary of Monetary Strategy Amidst Crisis: Most notable here is the way in which she differentiates current US Fed and past Japanese central bank strategies during our respective times of crisis.

The use of the Fed’s balance sheet to stimulate the economy might seem quite a lot like the “quantitative easing” policy pursued by the Bank of Japan in the early 2000s, when it was at the zero bound. However, to my mind, the differences outweigh the similarities. The main similarity is that the Fed, like the Bank of Japan, has increased the total quantity of bank reserves well above the minimum level required to push overnight interbank lending rates—in our case, the federal funds rate—to the vicinity of the zero bound. The creation of such a large volume of reserves, in the Fed’s case, results from the enormous expansion in discount window lending, foreign exchange swaps, and asset purchases through our various liquidity facilities. In the Bank of Japan’s case, the expansion in reserves resulted from the deliberate adoption of an explicit numerical target for them. The concept underlying the Bank of Japan’s intervention was that banks might be encouraged to lend by replacing their holdings of short-term government securities with excess cash. However, near the zero bound, short-term government securities and cash are almost perfect substitutes, so exchanging one for the other should have little effect on banks’ desire to lend. And the Japanese experience suggests that simply expanding bank reserves—even by a very large amount—had little effect on bank lending or on the economy more broadly.

The consequence of all of the Fed’s balance sheet initiatives is that our balance sheet has ballooned from about $900 billion at the beginning of 2008 to more than $2 trillion currently—and is rising. However, the impact of the totality of Fed programs should not be judged by the overall size of the Fed’s balance sheet. Instead, that size will be the result of decisions concerning the appropriate scale of each particular program and the extent to which the various programs and facilities are actually used by market participants. The take-up rates on these programs and facilities are likely to fluctuate over time as market conditions change. For example, early in a new Fed lending program, its impact on economic activity might rise with the associated expansion of the Fed’s balance sheet. Later on, if the program helps to improve the functioning of the private market, success could be associated with the contraction of the Fed’s balance sheet as the Fed exits from the market, leaving the determination of credit flows to private participants. Furthermore, the mere availability of backup liquidity through a facility may improve market functioning, even if the volume of borrowing is low.

 

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