Janet Yellen's Latest Economic Outlook
Don't look for anything new here: lots of optimism, lots of Okun's law references, and a whole lot of dovishness and "this time we know what we are doing."
- On unsustainable budgets
I’m no fan of persistently large budget deficits. I’ve warned against them throughout my career. But the real danger I see from them is not inflation. Rather, they may be harmful once the economy recovers because they are apt to boost interest rates and absorb private savings that would otherwise finance productive investments. This is potentially a serious problem in the long term that could reduce investment and lower living standards, although, in the short run, federal deficits have cushioned the blow from the financial crisis and recession. As far as inflation is concerned, there’s no evidence that big government deficits cause high inflation in advanced economies with independent central banks, such as the Fed. Japan is a case in point. Japan has run enormous fiscal deficits for many years and its government debt has risen to very high levels. Yet is has suffered from persistent deflation, not inflation.
- On the rate outlook
So where does all this leave Federal Reserve policy? Traditionally, the main tool of Fed monetary policy is the federal funds rate, which is what banks charge each other for overnight loans. The Fed controls that rate by varying the amount of reserves it supplies to the banking system and we have pushed that rate to zero for all practical purposes. This is as low as it can go. Such accommodative policy is appropriate, in my view, because the economy is operating well below its potential and inflation is undesirably low. I believe this is not the time to be removing monetary stimulus. Consistent with that view, the FOMC has repeatedly stated that it expects low interest rates to continue for an extended period.
As we carried out our emergency lending programs and eased monetary policy in response to the recession, our balance sheet swelled from roughly $800 billion to its current level of over $2.2 trillion. Despite the reduction in our lending programs, our balance sheet remains, for want of a better word, enormous, owing to our holdings of mortgage-backed securities and agency debt. Now I just said this is not the time to be tightening monetary policy. But eventually the economy will gain enough momentum and won’t need today’s extraordinarily low interest rates. When that time comes, we will begin to tighten policy and remove monetary stimulus. And when we start doing so, we will face some technical issues due to the size of the balance sheet, as Chairman Bernanke noted in recent Congressional testimony.
These aren’t normal times. Our securities purchases have caused the quantity of reserves in the banking system to swell to something like $1 trillion—far above the pre-crisis level of around $50 billion. If we were to follow our standard approach of selling securities to raise interest rates, we would have to sell off many hundreds of billions of dollars of securities to reduce the supply of reserves enough to have any chance of pushing rates higher. The problem with doing that is that such massive sales of mortgage-related and Treasury securities could be disruptive to markets and cause mortgage interest rates and other long-term rates to shoot up when we are still in the early stages of the recovery and the financial system, although improving, is still not at full health.
- And here is what Yellen wants to happen:
There is an alternative. To push up short-term interest rates without selling off our securities holdings, we can instead raise the interest rate that we pay on reserves held at the Fed. Because banks would have the opportunity to collect a higher reward for keeping funds on deposit at the Fed, they would demand commensurately higher returns on the overnight loans that they make in the federal funds market. So an increase in the interest rate paid on reserves would raise the fed funds rate and tighten financial conditions more generally. The ability to pay interest on the excess reserves that banks deposit with the Fed is an important new tool that Congress gave us just over a year ago. It will play a lead role when the time ultimately comes to tighten monetary policy. And, to make sure this works smoothly, we have developed some technical tools that can help keep the federal funds rate near our preferred target.5 Eventually, after economic conditions have improved and a policy tightening has begun, we may then start a gradual process of selling securities in order to help return the Fed’s balance sheet to its pre-crisis levels.