San Francisco Fed Makes The Case For ZIRP4EVA, Says No Need To Fix Fed's Bloated Balance Sheet

Tyler Durden's picture

Well, not really 4EVA, but the uberdovish FRBSF has just released a paper by Glenn Rudebusch, in which the author claims "that to deliver future monetary stimulus consistent with the past—and ignoring the zero lower bound—the funds rate would be negative until late 2012." In other words, a realistic outcome over the next two years will involve not only ZIRP, but additional QE to satisfy the differential to the zero limit. Furthermore, once the economy fully relapses into a double dip, which should be confirmed at the latest by September, Bernanke will have to flush even more money into a monetary stimulus rescue, as the president's fiscal hands will be tied in advance of a landslide mid-term election loss. One possibility is the passage of legislation which allows negative fed fund rates: when all else fails, US citizens will be directly penalized to save money. The recession will further push back the expiration of the "exceptional" and "extraordinary" language well past 2020, by which time all the primary dealers will have bought every single bond repoable back to the fed, gunned up stocks, paid up trillions in bonuses, and reinvested the proceeds in hard (gold) and liquid (Bordeaux) assets. And there you have your roadmap for the next decade.  And just in case a prudent voice of opposition to this insane policy were to arise, the author stops it dead in its tracks with the following illogical and non-sequitur statement: "the linkage between the level of short-term interest rates and the extent of financial imbalances is quite erratic and poorly understood." And now you know.

Full Fed paper:

The Fed's Exit Strategy for Monetary Policy

By Glenn D. Rudebusch

As the financial crisis has
receded, the Federal Reserve has scaled back its extraordinary
provision of liquidity. Eventually, the Fed will remove all remaining
monetary stimulus by raising the federal funds rate and shrinking its
balance sheet. The timing of such renormalizations depends crucially on
evolving economic conditions.

To many observers, the Federal Reserve’s extraordinary policy
actions during the recent crisis averted a financial Armageddon and
curtailed the depth and duration of the recession (Rudebusch 2009). To
combat panic and dislocation in financial markets, the Fed provided an
enormous amount of liquidity. To mitigate declines in spending and
employment, it reduced the federal funds interest rate—its usual policy
instrument—essentially to its lower bound of zero. To provide
additional monetary stimulus, the Fed turned to an unconventional
policy tool—purchases of longer-term securities—which led to an
enormous expansion of its balance sheet.

As financial market strains eased and economic recovery began,
discussion turned to how the Fed would unwind its actions (Bernanke
2010). Of course, after every recession, the Fed has to decide how
quickly to return monetary conditions to normal to forestall
inflationary pressures. This time, however, policy renormalization is
especially challenging because of the unprecedented economic conditions
and Fed actions. This Economic Letter
describes various considerations in formulating an appropriate policy
exit strategy. Such a strategy must unwind each of the Fed’s three key
actions: the establishment of special liquidity facilities, the
lowering of short-term interest rates, and the increase in the Fed’s
securities holdings.

Ending the Fed’s extraordinary provision of liquidity

Starting in August 2007, money markets experienced periods of
dysfunction with sharply higher short-term interest rates for
commercial paper and interbank borrowing. This intense liquidity
squeeze, in which even solvent borrowers found it difficult to secure
essential short-term funding, appeared likely to have severe financial
and economic repercussions. Therefore, the Fed, acting in its
traditional role as liquidity provider of last resort, introduced a
variety of special facilities to supply funds to banks and the broader
financial system.

By the end of 2008, the Fed was providing over $1½ trillion of
liquidity through short-term collateralized credit. Generally, this
liquidity was designed to cost more than private credit when financial
markets were functioning normally. Therefore, as financial conditions
improved during 2009, borrowers switched to private financing. By early
2010, demand had dried up for the Fed’s special facilities and they
were closed. The facilities incurred no credit losses and provided a
sizable return of interest income to taxpayers. More importantly, the
liquidity facilities helped limit a pernicious financial and economic
crisis (Christensen, Lopez, and Rudebusch 2009).

Raising short-term interest rates

Figure 1
Federal funds target rate and simple policy rule

Federal funds target rate and simple policy rule

A rule of thumb that summarizes the Fed’s policy response over the
past two decades can be obtained by a statistical regression of the
funds rate on core consumer price inflation and on the gap between the
unemployment rate and the Congressional Budget Office’s estimate of the
natural, or normal, rate of unemployment (Rudebusch 2009). The
resulting simple policy guideline recommends lowering the funds rate by
1.3 percentage points if inflation falls by 1 percentage point and by
almost 2 percentage points if the unemployment rate rises by 1
percentage point. As shown in Figure 1, this rule of thumb captures the
broad contour of the actual target funds rate during late 2007 and 2008
when, as the economy slowed, the Fed lowered its target by over 5
percentage points to essentially zero. In 2009, as the recession
deepened and inflation slowed, this rule of thumb indicates that—if it
had been possible—another 5 percentage point reduction in the funds
rate would have been consistent with the Fed’s historical policy
response. Of course, interest rates can’t really fall below zero, since
any potential lender would rather hold cash. So the Fed ran out of room
to push the funds rate lower and has held it near zero for over a year.

Figure 1 also provides a simple perspective on when the Fed should
raise the funds rate. The dashed line combines the benchmark rule of
thumb with the Federal Open Market Committee’s median economic
forecasts (FOMC 2010), which predict slowly falling unemployment and
continued low inflation. The dashed line shows that to deliver future
monetary stimulus consistent with the past—and ignoring the zero lower
bound—the funds rate would be negative until late 2012.
In practice,
this suggests little need to raise the funds rate target above its zero
lower bound anytime soon. This implication is consistent with the Fed’s
forward-looking policy guidance (FOMC 2010) that “economic
conditions—including low rates of resource utilization, subdued
inflation trends, and stable inflation expectations—are likely to
warrant exceptionally low levels of the federal funds rate for an
extended period.”
This guidance indicates that the length of the
“extended period” depends on the expected path of unemployment and
inflation. Similarly, the benchmark policy rule would prescribe an
earlier or later increase in the funds rate if unemployment or
inflation rose or fell more rapidly than predicted in the forecasts
underlying Figure 1.

Still, a variety of complications are ignored in the simple analysis in
Figure 1. For example, the asymmetric risk associated with the zero
bound on interest rates could potentially lengthen the “extended
period” (see FOMC 2010). If monetary policy is tightened prematurely,
it would be hard to reverse course significantly because of the zero
bound constraint. However, if tightening is started late and economic
growth exceeds expectations, there would be ample scope for greater
monetary restraint by raising rates at a rapid pace. The greater risk
associated with raising rates too early suggests postponing an initial
increase in the funds rate relative to Figure 1.

In contrast, some have argued that holding short-term interest rates
near zero for much longer could foster dangerous financial imbalances,
such as asset price misalignments, bubbles, or excessive leverage and
speculation (see FOMC 2010). The risk of such financial side effects
could shorten the appropriate length of a near-zero funds rate.
However, the linkage between the level of short-term interest rates and
the extent of financial imbalances is quite erratic and poorly
. For example, during the past decade and a half, Japanese
short-term interest rates have been essentially at zero with no sign of
building financial imbalances. Therefore, some remain skeptical that
monetary policy should directly aim to restrain excessive financial
speculation, especially while prudential financial regulation remains
available for this task (Kohn 2010).

Figure 2
Federal Reserve securities holdings

Federal Reserve securities holdings

A third factor not captured in Figure 1 is the Fed’s unconventional
monetary policy. Even though the funds rate was pushed to its zero
lower bound by the end of 2008, considerable scope remained to lower
long-term interest rates. To do this, the Fed started buying
longer-term Treasury and federal agency debt securities (including
mortgage-backed securities), as shown in Figure 2. The Fed’s purchases
appeared to increase the demand and price for these securities, which
lowered the associated longer-term interest rates. One estimate
suggests that the Fed’s announcements in late 2008 and early 2009 of
future securities purchases caused 10-year yields to fall by about ½ to
¾ of a percentage point (Gagnon et al. 2010).

Figure 3
Funds rate rule adjusted for unconventional policy

Funds rate rule adjusted for unconventional policy

The additional stimulus from the Fed’s unconventional monetary
policy implies that the appropriate level of short-term interest rates
would be higher than shown in Figure 1. That is, conventional policy
(the funds rate) can do less because of the stimulus to growth from
unconventional policy. In calibrating this effect, it is important to
note that changes in long-term interest rates have much larger effects
on the economy than equal-sized changes in short-term interest rates.
For example, the output sensitivity to movements in the 10-year yield
estimated by Fuhrer and Moore (1995) is quadruple the output
sensitivity to a short-term interest rate in Rudebusch (2002). If the
Fed’s purchases reduced long rates by ½ to ¾ of a percentage point, the
resulting stimulus would be very roughly equal to a 1½ to 3 percentage
point cut in the funds rate. Assuming unconventional policy stimulus is
maintained, then the recommended target funds rate from the simple
policy rule could be adjusted up by approximately 2¼ percentage points,
as shown in Figure 3, and the recommended period of a near-zero funds
rate would end at the beginning of 2012.

Returning the Fed’s balance sheet to normal

An important part of the Fed’s exit strategy involves returning the
level and composition of its balance sheet to pre-crisis norms. Since
conventional and unconventional Fed policies provide complementary
monetary stimulus, the renormalizations of the funds rate and the Fed’s
portfolio of securities should be coordinated. In theory, the Fed could
respond to a faster or slower economic recovery by adjusting both the
pace of tightening of the funds rate and the speed of the reductions in
its securities holdings. However, there is little historical experience
to help predict the timing and magnitude of the effects of selling
securities. This uncertainty suggests that balance sheet
renormalization should proceed cautiously and that short-term interest
rates should remain the key tool of monetary policy.
Indeed, a majority
of the FOMC (2010) “preferred beginning asset sales some time after the
first increase in the FOMC’s target for short-term interest rates.”

Figure 4
Fed's balance sheet and expected inflation

Fed's balance sheet and expected inflation

In contrast, some worry that maintaining a large Fed balance sheet
with substantial holdings of securities as assets and bank reserves as
liabilities could trigger an unwelcome rise in inflation expectations
and inflation. However, as shown in Figure 4, the doubling of the Fed’s
balance sheet has had no discernible effect on long-run inflation
expectations measured in the Survey of Professional Forecasters. This
insensitivity of inflation to an enlarged central bank balance sheet is
consistent with Japan’s decade-long spell of price deflation. A second
worry about a continuing high level of bank reserves is that they may
impede the use of short-term interest rates as the monetary policy
instrument. However, the experience of foreign central banks suggests
that the Fed will be able to control the level of short-term interest
rates by varying the interest rate on bank reserves (Bowman, Gagnon,
and Leahy 2010).

Another worry about deferring balance sheet renormalization is the
potential for future losses on the Fed’s portfolio of securities if
long-term interest rates rise. However, a central bank has access to an
indefinite stream of future earnings from assets bought with currency
(that is, seigniorage). So, many feel that, unlike for a private
financial institution, such interest rate risk is of little
consequence. Finally, some worry that holding Treasury securities could
be seen as “monetizing” government debt, while others are concerned
that holding federal agency securities gives the appearance of
“allocating credit” in the private sector. Currently though, with
Fannie Mae and Freddie Mac in government conservatorship, the
delineation between Treasury and agency securities has been greatly


Many predict that the economy will take years to return to full
employment and that inflation will remain very low. If so, it seems
likely that the Fed’s exit from the current accommodative stance of
monetary policy will take a significant period of time.

Glenn D. Rudebusch is senior vice president and associate director of research at the Federal Reserve Bank of San Francisco.

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John McCloy's picture

OT: Senator Blanche Lincoln considering selling out Americans right after winning the primary by bowing down to Dodd, the Fed & the banksters:

I suggest anyone in Arkansas to email or call Lincoln with your strong opposition to any changes that would permit banks to continue to transfer our savings into their accounts.

RockyRacoon's picture

As an Arkansan I can state that Ms Lincoln is a tool.   There are currently some really serious run-off election poll problems.  These will come to naught, of course.  One should not be surprised at anything coming from the Lincoln camp.

nevadan's picture

The inmates are running the asylum.

hedgeless_horseman's picture

And now you know.

And knowing is half the battle. 

ZI Joe is there!

ZI Joe,

A great American hero.

He'll fight for freedom wherever there's a bubble,

ZI Joe is there,

ZI Joe!

Cognitive Dissonance's picture

Personally I'm waiting for free money, where they just send me checks because I flush the toilet in the morning and think about the Fed when I visit the urinal.

Problem Is's picture

Flushing your toilet after wiping with Bernank-ster Bucks is deflationary...

Stop it!

Cognitive Dissonance's picture

You have me all wrong Dear Sir. The Fed's toilet paper is high quality linen. Once a week I wash a load of them up using Tide and Clorox, gently tumble dry using the wash and wipe dryer settings and place them next to the throne for reuse.

I Dear Sir am being frugal.

Eally Ucked's picture

My advice is to improve process by adding some Fleece  to drying stage for increased fluffiness and wipe efficiency.

Mitchman's picture

"Fleece" although unintentionally meant, is exactly the right product!

RockyRacoon's picture

No way I'm getting in the middle of this wipe-fest.   But I will concede that CD is a Charmin fellow.

equity_momo's picture

Get set for 15 dollar box's of Cheerios and 100k McMansions.

mmmmmmm squeeze.

Joe Shmoe's picture

So, in SF, they're essentially saying that the economy won't recover 4eva so they can't raise rates before then.  But even so, it's okay to bloat the balance sheet (and degrade its quality).  But, then Bernake says there's not a likelihood of double dip and that the economy is recovering.  Seems kinda inconsistent.

Problem Is's picture

This kind of logic out of Yellen's SF Fed is EXACTLY why Janet-baby deserves to be on the Fed Official Board of Idiots...

AR15AU's picture

These idiots actually believe that our problem is a lack of credit...

BobWatNorCal's picture

I believe they think the problem is that we are under-taxed.

John McCloy's picture

  Isn't it beautiful when you control the U.S. government?

  Only if we were in full blown bubble mode would they raise rates. Even as the false data has been showing supposed improvement they will continue to leave rates at 0% simply to ensure a bubble. They are playing for keeps and are ready to go down with the ship in an attempt to prove their belief that money solves all problems.

buzzsaw99's picture

Let's see, every time there is a crisis it is met by giving more money to the uber-fascist banks and more power to the criminal fed. Gee, I don't understand why we keep having all these crises. [/sarcasm]

Sancho Ponzi's picture

'curtailed the' 'duration of the recession?' That's a joke, right? 

MayIMommaDogFace2theBananaPatch's picture

They meant to say 'diminished' the 'tenor' of the recession, which is imbued with so much more, uh, more -- meaning...

Rider's picture

NEGATIVE RATES !!?  This punk is Loco, Wako, Weirdo!

MayIMommaDogFace2theBananaPatch's picture

They've been floating this idea here-and-there for at least a year. 

Have some fun: go ask a sheeple who 'invests' to try and explain the logic of negative-interest-rates to you.

When they fail to even begin to try to explain, and then resort to telling you that your idea about negative-interest-rates is INSANE -- then you calmly tell them that you agree completely and that this 'idea' is coming from TPTB...

THE LOOKS ARE PRICELESS.  Try it and see...

Snidley Whipsnae's picture

A couple of real jewels...Time date the money so that if not spent it expires useless!

Hold a yearly lottery so that certain serial numbers of FRNs are declared useless. If you happen to be holding the useless serial numbers you are wiped out.

The Fed is about as far from the Austrian approach as possible.

I am about as fed up with the Fed as is possible for one individual to be. We are along for the ride because ~ 1/2 of the population is on some type of Gov assistance.

The explosion will come and I have my earplugs in my shirt pocket.

ElTerco's picture

Hey, now that it's spring/summer, what better way to clean out those bank vaults than negative rates?  I'd certainly go down and help them get rid of that messy cash they are holding for me.

centerline's picture

The last two paragraphs are priceless as well.   Assumption of the mechanics of inflation flawed to the core (ignores currency crisis and the social mechanics of inflation).  And the argument of seigniorage is simply insane....the "indefinite stream..."  ha ha ha ha.  Someone needs to lay off the mind-altering drugs over there in SF.

taraxias's picture

Just in case any of you thought that when Bernokio puts a 1911 in his mouth and pulls the trigger that it'll be the end of this, Janet Yellen is standing by in the wings.

Catullus's picture

I love the thinking here: holding onto all of these massive reserves at the fed can't be inflationary because the survey of economists' expectations hasn't risen since the balance sheet increase. All of these massive reserves can't possibly be inflationary because no one who we trust thinks there will be price inflation.

For those of you who are deflationistas, you are on the side of the fed. They're taking your argument of "forget about the purchasing of assets and massive reserves, it hasn't manifested itself yet, so therefore it never will". I'm sticking with "take every dollar the fed prints and mulitply it by 50 and that's the impact on the money supply eventually". We've been fortunate to this point that the fractional reserve process is inefficient at this point. We won't be lucky forever.

Muir's picture

And the struggle between inflation(FED) and deflation (most everywhere else that one cares to look) continues.

Will the bubblelicious FED or reality (credit destruction) triumph?

Stay tuned for another exiting episode!

Jim in MN's picture

But they are right, just lying about WHY they're right.  The reason is because of The Policy, which is no haircuts/writeoffs of the toxic MBS and other rotten bonds.


Instead of thinking of a way to accomplish mark to market and orderly writedowns, they relegate the US to a Lost Generation megaJapanese policy.  It is insane, but it is also deliberate.


There is a way out: Progressive bond haircuts, using some compensatory mechanism for the lower and middle income brackets.  But the fact that you have never read these words or seen this concept before is ipso facto ironclad proof that we are fucked, in order to preserve the fantasy asset valuations of banksters, the uberrich, and foreign interests.


Read it and weep for our Republic.  Ben Franklin said "if you can keep it" and we either fight through this or fail. 


No bond haircuts, no working economy EVAH AGAIN.

crzyhun's picture

More Keysensian falderall!! We are going no where fast. And so we are falling in to the pit of debt greased by fractional banks ad absurdum!

DoctoRx's picture

The whole piece is gobbledegook.  Here is what it says about Japan:

For example, during the past decade and a half, Japanese short-term interest rates have been essentially at zero with no sign of building financial imbalances.

No sign of building financial imbalances?  I know they're into marijuana in SF . . . what is this man smoking?

trillion_dollar_deficit's picture

Well on the way to the Fed's balance sheet equaling the national debt.

Amsterdammer's picture

Reminds me of Bernankenstein's speech last

week in Detroit: high unemployment is

starting to get costly for the US....

economicmorphine's picture

Looks like the playbook has one page.

JohnG's picture

With REAL inflation running at a 5%+, ZIRP, and 0.75% yields on my savings, I'm experiencing zegative interest RIGHT THE FUCK NOW, and it is absolutely killing me.

Save, save, save for my entire life only to watch it evaporate.

If this keeps up...I'll be living in a trailer park, if I can afford that.

Otherwise, I suppose it'll be a goddamn hole in the ground for me.

DosZap's picture

"Save, save, save for my entire life only to watch it evaporate".

Member of that club, you already lost your rights to MC/SS, you know, those FREE paychecks and services,you never paid a dime for?,

How many hundreds of thousands did that set you back, now, the rest is on the line.

Wait till they start actually IN WRITING, start charging your account for simply having one,on YOUR Balances.

Not just Fee's for services rendered.Just to HOLD it for you.

NO matter the size.............REAL inflation is closer to 10%, not 5%.( ShadowStats).


Dr. Sandi's picture

I'm buying actual, I can hold it in my hand, silver whenever there's some extra cash.

Banking at the credit union that accepts anybody who lives in this county. Free accounts and the checking balance stays here in town. Yeah, they still clear the checks through the FDIC, but who has money to buy stuff with checks anymore anyway?


jkruffin's picture

Heck, we are already being punished if we save.  When you have banks paying .25% on savings accts, and 13wk T-bills going for .065% like today, the only thing they have left is just take your money, which is probably the plan all along.

The Franchise's picture

Bernanke hearts ZIRP.