Monetary Policy Tool Kit

The One Question They Should Have Asked Janet Yellen

by Elaine Schwartz    •    Nov 19, 2013    •    1443 Views

Quartz Bingo Card for Janet Yellen confirmation Senate testimony.

This bingo card was tweeted by Quartz just before Fed chair nominee Janet Yellen spoke to the Senate Committee on Banking, Housing and Urban Affairs. It reminded me that Monetary Policy is not what it used to be.

For years, teaching monetary policy was relatively easy. The problems were recession/unemployment or inflation and occasionally both. The monetary solution was interest rates. Hoping to diminish the incentive to borrow, the Fed raised rates to attack inflation. On the other hand, if the goal was to fight a recession, they accelerated economic activity by guiding rates down.

Discussing how the Fed achieved its goals, I referred to its tool kit:

  • the fed funds rate: Appropriately targeted, the bank to bank loan rate could go up or down.
  • the discount rate: The Fed could lend cheap or expensive money to banks.
  • banks’ reserve requirement: Less frequently used, the money banks had to retain for each deposit could change.

Then the Great Recession came along and the usual tools did not work. Although interest rates had plunged, there was still little borrowing. So Dr. Bernanke decided to add Quantitative Easing to the Fed’s tool box. And soon, the Fed was buying additional treasury securities to make their yields drop and purchasing mortgage-backed securities from financial institutions to replace low quality investments with “cash.”  As treasuries became less attractive because Fed purchases made their return sink, banks would want to loan the new “cash” rather than making more conservative investments.

It did not work out exactly as they had hoped.

And yet, during Janet Yellen’s almost 2 1/2 hour long Senate testimony, no one focused on what former Treasury Secretary Larry Summers and Nobel Laureate Paul Krugman both said was the central issue facing the Fed and indeed even the entire economy.

Zero interest rates.

Referring to the massive declines in GDP during the Great Recession, Dr. Summers said he would, “Kinda expect that there would be a lot of catch-up” during the subsequent 4 year recovery. But there was not. He then asks why and suggests that we might even need interest rates to touch negative 2% or negative 3% for employment to recover.

But negative interest rates introduce new problems. And, we have not solved our old problems.

So, he concludes by asking about the “lessons from this crisis” and says, “I think that [what the] world has underinternalized is that it is not over until it is over, and that is surely not right now…and that we may well need in the years ahead to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activities, holding our economies back below their potential.”

Interesting and understandable, his entire 16 minute talk is well worth your time.

The one question they should have asked Janet Yellen? Located in the bottom row of Quartz’s bingo card, zero lower bound makes us wonder whether the Fed’s toolbox is equipped to manage zero interest rates.

Sources and Resources: H/T to Business Insider for the Summers speech alert and summary while Paul Krugman’s response provided further insight. The next possible step, if you want to pursue the dilemma further is this Economist blog and the Fed paper on which it was based. Finally, FT has the perfect blog that followed Yellen’s testimony and other tweets like the Quartz bingo card.


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