Historically, the U.S. Federal Reserve had one primary tool it reached for when it needed to edit the monetary environment. That tool was the raising or lowering of the federal funds rate, which is the interest rate at which banks — that is, depository institutions — can trade their federal funds, also known as reserves.
This rate serves as a benchmark for other interest rates throughout the financial market. When it is lowered, interest rates in general tend to decrease; when it is raised, interest rates tend to increase. Low interest rates help stimulate economic activity by encouraging borrowing and spending: Businesses can more easily access credit to buy capital or expand payrolls, and consumers can access cheaper loans for automobiles or home purchases. Higher interest rates tend to have the opposite effect.
This tool, simple as it may seem at first glance, is enormously powerful. In many ways, interest rates are the beating heart of the financial sector, and the Fed has its hand wrapped tightly around the muscle. The federal funds rate in particular can be used as a liquidity throttle. This is why in 2008, as the financial crisis wreaked wanton destruction through the banking system and credit markets began to seize, the Fed slashed the federal funds rate to the zero bound.
And in an effort to keep interest rates low and credit-accessible, the federal funds rate has remained at the zero bound since December 2008.
From here, the unconventional monetary policy that has defined the post-crisis era seems to evolve naturally. Speaking at the annual Economists Club dinner in Washington, D.C., on Tuesday, Fed Chair Ben Bernanke articulated how the problems with a zero-bound federal funds rate forced policymakers to fashion and adopt new tools to combat the recession.
“A federal funds rate effectively at zero created an important asymmetry for policy planning,” he said. “On the one hand, if the economy were to recover rapidly and inflation were to increase, monetary policymakers would be able to respond in the normal way, by raising the federal funds rate. But, on the other hand, if the economy were to remain weak or recover only gradually — the case we actually faced — the FOMC would not be able to cut the funds rate further.”
Bernanke continued: “The committee faced a situation in which more monetary policy accommodation was needed and possibly for quite a long time — yet its basic policy tool, the federal funds rate target, had been pushed to its limit.”
So what’s a policymaker to do? Reducing the target federal funds rate to a negative value is not a reasonable answer. From this conundrum emerged the two primary unconventional tools currently in use by the Fed: quantitative easing and forward guidance.
Through its program of quantitative easing, the Federal Reserve is trying to maintain downward pressure on interest rates by purchasing $85 billion worth of agency mortgage-backed securities and longer-term Securities in the open market each month. There’s a lot to unpack about this program by itself, but that’s beyond the scope of this article. On Tuesday, Bernanke spoke specifically about forward guidance and how simply communicating more effectively with investors and the public could be a policy tool.
“The public’s expectations about future monetary policy actions matter today because those expectations have important effects on current financial conditions, which in turn affect output, employment, and inflation over time,” said Bernanke. “For example, because investors can choose freely between holding a longer-term security or rolling over a sequence of short-term securities, longer-term interest rates today are closely linked to market participants’ expectations of how short-term rates will evolve.”
It is in this spirit that the Fed has established its policy of forward guidance. As of September, as outlined by the Federal Open Market Committee’s statement on monetary policy, that guidance looked like this:
“The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains about 6-1/2 percent, inflation between one and two years ahead is projected to be no more than half a percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”