Fed policy: good intentions, risky consequences.

• Author: Plosser, Charles L.

The last five years have been an extraordinary time for the global economy and monetary policymakers. The financial crisis and the severe global recession that followed have tested our resolve, our patience, and our economic theories. To restore the health of ailing financial markets and economies, central banks have driven short-term interest rates to essentially zero, expanded their balance sheets to unprecedented levels, and engaged in market interventions that have blurred the lines between monetary policy and fiscal policy.

These extraordinary efforts were well intentioned. Although it will be some time before we fully understand the effectiveness of various actions, some have credited them with preserving financial markets and saving the global economy from an even deeper recession. Yet, these actions also carry long-term risks for our economies and for central banks.

In this article, I focus on U.S. monetary policy and discuss some of the longer-term risks arising from the Federal Reserve's policy responses to the financial crisis and slow recovery. I then discuss an approach to monetary policy that I believe would prove beneficial in the post-crisis economy.

The Risks of Extraordinary Accommodation and Nontraditional Policies

Let me begin by reviewing the extraordinary actions taken by the Federal Reserve as it attempted to maintain liquidity and the basic functioning of our financial markets and subsequently to support an economic recovery.

During the height of the crisis, the Fed instituted various liquidity facilities for particular segments of the financial system that were under stress. These programs supported primary dealers, the commercial paper market, and money market fund investors. The Fed also gave support to specific individual institutions, including Bear Steams and AIG, to avert what could have been disorderly failures.

After reducing its policy rate, the fed funds rate, to essentially zero, the Fed instituted several large-scale asset-purchase programs. The first of these programs of quantitative easing, commonly referred to as QE1, ultimately involved purchasing $175 billion of housing agency debt and $1.25 trillion of agency mortgage-backed securities, or MBS; the Fed also purchased $300 billion in longer-term Treasuries in 2009. The unprecedented purchases of significant quantities of MBS were intended to support housing--the specific sector of the economy ha which the financial crisis was centered.

As market functioning returned to normal, large-scale asset purchases continued. But the purpose shifted to providing monetary stimulus or defending against the potential for deflation while the Fed's policy instrument was constrained by the zero lower bound rather than supporting market functioning or lender-of-last-resort activities. As the economy straggled to recover and deflation became a concern, the Fed implemented QE2, a program to purchase $600 billion in longer-term Treasury securities. Most recently, the Fed instituted QE3, an open-ended program to purchase agency MBS at a pace of $40 billion per month and then added purchases of $45 billion in longer-term Treasuries per month. Since the Fed is also reinvesting proceeds of maturing or prepaid MBS securities into MBS and is rolling over maturing Treasury securities at auction, the Fed's balance sheet is growing at a pace of about $85 billion a month.

In addition to the asset-purchase programs, the Fed also implemented a maturity extension program, popularly referred to as Operation Twist--an intervention that was last attempted, with little success, in the 1960s. The objective of this program was to flatten the yield curve by removing duration from the market. (1) Finally, the Fed has attempted to alter public expectations of the future path of monetary policy and the economy by issuing forward guidance about how long it expects to keep the fed funds rate exceptionally low."

As a result of these policy initiatives, the Fed has now held its policy rate near zero for more than four years, its balance sheet is almost four times larger than before the crisis, and the composition of its balance sheet has shifted toward longer-term housing-related and Treasury securities compared with mostly short-term Treasury securities held before the crisis. Indeed, the Fed now holds no short-term Treasuries.

Despite these extraordinary efforts by the Fed, the economic recovery has been lackluster--unemployment remains uncomfortably high and is declining slowly, economic growth is moderate, and confidence in the future is not strong.

Looking at this state of economic affairs, one might conclude that the Fed just hasn't done enough. Since the Fed seems to be missing on the employment part of its dual mandate, some suggest the Fed can and should continue to pursue more accommodation as long as inflation remains contained. But this is not the only conclusion one could draw from the evidence. Instead, one could conclude that the factors contributing to mediocre economic performance cannot be offset by monetary policy.

This alternative hypothesis should not come entirely as a...