What actions will the FED take during next recession?

On August, 26th 2016 Janet Yellen presented a paper called “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, Future” during annual central bankers’ symposium in Jackson Hole, Wyoming.

Click to access yellen20160826a.pdf

The paper is worthy to read as it gives some valuable insight on what are possible monetary manipulations FED would apply during next financial crisis or recession. Being able to foresee the direction and magnitude of FED’s actions could give investors a valuable investment edge in the future.

Janet Yellen has focused her attention on the results of the macroeconomic simulation performed using FRB/US model. FRB/US is a macroeconomic model developed by some of the FED acedemics, which is used as a guidance in analyzing potential monetary and fiscal tools. The goal of the simulations was to identify the effectiveness of different monetary actions which could potentially be employed by the FED as a response to the next recession. Specifically, the model helps to identify which which monetary measures would be most useful in achieving FED’s goal: inflation rate of 2% and unemployment rate below 5%.

There are three scenarios analysed by the model:

1) In the first scenario, there is no lower bound limitation, which means that FED is allowed to set nominal interest rates below zero. In this scenario FED can cut the rates as low as it wishes. There is no formal restrictions in terms of the lower bound of interest rates. We already know that nominal negative interest rates are possible in practice (contrary to what ivory tower, mainstream “economist” has written down in their textbooks). ECB, Bank of Japan, Swiss National Bank, Riksbanken and Danmarks Nationalbank have all done it.

2) In the second scenario FED would simply lower the interest rates to the zero lower bound (interest rates at 0%). There would be no additional monetary “stimulation” such as Quantitative Easing.

3) The third scenario assumes lowering interest rates to zero as well as introduction of 2 trillion Asset Purchasing Programme (QE), as well as forward guidance where FED declares to keep interest rates at zero for a prolonged period of time. Experience can tell us that a prolonged period of time means as long as FED deems appropriate.

Yellen states that the most effective scenario from the perspective of FED’s goal is the scenario number 3. The direct effect which Yellen predicts as the consequence of the third scenario is reduction in long-term interest rates. She thinks that measures assumed in this scenario would help to achieve FED’s goals in the shortest period of time.

Yellen has raised warnings that the assumed effectiveness of the next QE embodied in the model as well as of the forward guidance could be overoptimistic. Especially, in the environment where interest rates were extraordinary low for the extended period of time. She seems to be suspecting that the future effectiveness of the previously used tools (such as lowering rates or QE programs) can be less in the future comparing to its effectiveness from the past. She claims that the model is too optimistic in its base assumption as to the level of interest rates when the next recession starts. The model assumes that the interest rates in the starting position are set at 4%, which is only slightly lower than pre-2007/2008-crisis times. Current interest are lower than 4% and Yellen believes that the more reasonable assumption would be 2% as the starting point. She either has no plan to raise rates more than 2% or she expects that the next recession would arrive before the interest rates have risen to 4%. In regards to long-term interest rates she specifically mention that the long term interest rates are at 3%, comparing to average 7% between 1965 and 2000.

Yellen seems to ignore the first and second scenario as not aggressive enough to handle next recession.

In the footnotes she cites another simulation performed by Reifschneider, “Gauging the Ability of the FOMC to Respond to Future Recessions”. This model claims that the next monetary intervention would require lowering interest rates to zero, forward guidance and QE of 4$ trillion (rather than 2$ trillion proposed the model). This would almost double FED’s balance sheet (again!) from current $4.4 trillion to over $8 trillion.

It’s quite interesting that academics from the same institution can propose monetary experiments of materially different size. The difference between two proposals is 100% ($2 and $4 trillion). The difference between these two proposals is so staggering that it’s difficult to believe that any model used by FED has any real viable application. FED is unsure whether it should acquire assets which are worth 11% of the American GDP (equal to almost $18 trillion), or they should buy another assets worth 22% of the US GDP. According to some FED academic, more realistically the next QE would be equal to 22% of the US GDP and total FED’s balance sheet would increase to 46% of US GDP. Let’s put this into perspective. In 2007, in the aftermath of the global financial crisis, the FED’s balance sheet was around $0.8 trillion, which was equal to 5% of US GDP ($14 trillion at the time).

Why Yellen seems to be skeptical that traditional rate cuts wouldn’t be enough to “stimulate” the economy during next crisis/recession?

She refers to the previous recessions when the long-term interest rates in the pre-recession period were much higher. During previous recessions, FED cut interest rates on average by 5.5%, with 3% minimum cut during soft recessions and 10% during severe crisis. Assuming 3% present in the current environment, if FED wanted to fight a severe crisis using interest rates manipulation only it would have to lower the long term interest rates to -7%, or to -2.5% during an average recession.


In order to add some hope to the a rather gloomy outlook, she claims that in the periods preceding last seven recessions, the monetary policy was too tight (interest rates were too high). She claims that the tight policy in the past was due to the “elevated inflationary pressures” in the period prior to the recessions. High interest rates were introduced to fight the inflation, and therefore had to be slashed from higher than “optimal” level. She doesn’t exclude that a similar situation would take place again. If it did happen, she assumes the pre-recession interest rates level would be higher than current 3%. Therefore, FED would have more “space” to lower the rates.

Janet Yellen expresses her doubts as to whether the policy actions proposed by the model would be adequate to respond to a recession if it happens now (when short term interest are lower than assumed in the model). She then proceeds to enlist possible monetary actions which have not been used by the FED yet (some of which would require legislation change), and which are supposed to supplement the ones embedded in the model.

1) Possibility to purchase a broader range of assets similar to these purchased by other central banks (ECB buys corporate bonds, and BoJ & SNB buy equities). Actually, confiscation would be a more accurate terms, as central banks just credit the money they need by simply booking the trillions they need on their books. Purchasing, confiscating, magin? Who knows what the proper term is.

2) Raising FED’s inflation objective above 2%

3) Monetary policy based on different targets (like price-level or Nominal GDP targeting)

4) Fiscal stimulus

5) Improving educational system (by the government I assume 😀 How about the government improving and reforming the education system for the last century, and the result is that some central banker is concerned about the quality of the system?)

6) Promoting capital investment (I though low interest rates of the last decades were supposed to do achieve this?)

7) R&D spending (see point 6)

And finally,

8) Reducing regulatory burden (one sensible proposal in the 22 pages full of non-sense, not too bad)

Even though Yellen is very cautious in suggesting that FED would consider using any of the “non-standard” measures, it seems reasonable to assume that the following monetary tools would be used in case the US economy got hit by a financial crisis or/and a recession in the first place.

– introducing negative interest rates

– doubling FED’s balance sheet by purchasing $4 trillion of assets (treasuries, MBS, corporate bonds, equities)

– forward guidance = low interest rates for longer, and longer, and longer…

– all other mentioned in the last paragraph

Lots of „great” ideas. But how about just „End the FED”?

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