Charles Evans' view on unconventional monetary policy in Istanbul (Part 3 of 5)
Chicago Fed’s Charles Evans discusses policies to overcome ZLB constraints
Chicago Fed president and chief executive officer (or CEO), Dr. Charles Evans, was the keynote speaker at the Macro Workshop, 2014 organized by the Central Bank of Turkey at the Istanbul School of Central Banking on June 2–3. The topic for the presentation was “A Perspective on Unconventional Monetary Policy.” In his presentation, Dr. Evans discussed why the Fed’s monetary policy was constrained by the Zero Lower Bound (or ZLB) of the Fed funds rate. In this section, we will discuss the tools he talked about that could be used to overcome these constraints. Using an optimal policy approach, like the use of Taylor rules, would minimize deviations from the Fed’s inflation and employment targets. He recommended the following tools to overcome ZLB constraints:
- State-contingent price level targeting
- Large Scale Asset Purchases (or LSAPs)
- Forward guidance and inertial policy rule
State-contingent price level targeting
Dr. Evans has been a vocal proponent of state-contingent price level targeting—under certain conditions. When inflation is persistently below the Fed’s targeted 2% level, he recommends a monetary policy that targets price-levels in the economy. This would bring about above-average inflation for a temporary period. Once the inflation target was reached, the central bank would progressively scale down its monetary stimulus policies. However, the central bank must clearly communicate its intentions to financial markets before embarking on price-level targeting. Exit conditions from such a strategy must also be clearly specified.
“A central bank exercising this policy would have to credibly convey to the public that this policy will end when the price gap is closed,” said Dr. Evans, in a speech at the Boston Fed’s 55th Economic Conference on October 16, 2010.
Large Scale Asset Purchases (or LSAPs)
Open market purchases of government securities is another monetary stimulus tool that is being used by the Fed. Currently, the Fed purchases $25 billion of long-term Treasury securities (TLT) and agency-backed securities (MBB) each month. The original level of LSAPs was $85 billion per month, $45 billion of longer-term Treasuries, and $40 billion of agency-backed securities. The Fed has since tapered part of the LSAPs, by announcing a reduction in these purchases by $10 billion at each of its last four Federal Open Market Committee (or FOMC) meetings. These purchases have had the impact of increasing market liquidity, in the hope of improving credit conditions that would help stimulate private investment. Higher investment in the economy would help economic growth and generate jobs. All else equal, increasing market liquidity would also increase inflation to its long-term target rate.
On the impact of LSAPs
In his presentation, Dr. Evans mentioned that LSAPs had impacted long-term interest rates through the portfolio balance effects of term premia, saying that while there were a “wide range of estimates regarding the effect of LSAP on Treasury rates,” a “reasonable estimate is $500 billion of LSAP worth about 25 bps on 10-year Treasury rates.” He also said that LSAPs had impacted Treasury rates due to the “signaling effect on expected future short-term rates.”
Implications for investor
However, while an accommodative monetary policy has helped bring non-farm jobs to almost pre-recession levels, inflation has persisted below the Fed’s targeted rate of 2%. Also, companies have taken advantage of low interest rates to re-finance costlier debt, fund merger and acquisitions, and increase returns for shareholders by increasing dividends and share-buybacks. The S&P 100 Buyback Index, which monitors 100 stocks with the highest buyback ratios, increased by 45% in 2013, shadowing the performance of the S&P 500 Index (SPY) which increased by 28%.
Inflation and employment increase, but still short of Fed’s targets
In April, 2014, the Fed’s preferred inflation measure, the change in Personal Consumption Expenditure (or PCE), increased by an annualized rate of 1.6%—the highest level in over a year. That said, inflation is still short of the Fed’s target level and the unemployment rate (6.3% in April, 2014) is lagging the sustainable full employment levels of 5.2%–5.6%.
Accommodative monetary policy has reduced the yields on debt securities to historical lows and resulted in a singular bull market in bonds over the period 2010–2012, including U.S. Treasuries (IEF), investment-grade corporate debt, and high-yield corporate debt (JNK).
SPY is the State Street SPDR S&P 500 ETF, which tracks the S&P 500 Index. IEF is the iShares 7–10 Year Treasury Bond ETF. TLT is the iShares 20+ Year Treasury Bond ETF. MBB is the iShares Barclays MBS Fixed-Rate Bond Fund. JNK is the SPDR Barclays Capital High Yield Bond ETF.
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