Upgrading the Fed's Operating Framework.

• Author: Beckworth, David

U.S. monetary policy has undergone a lot of change over the past decade, including the arrival of large-scale asset purchases (LSAPs), the elevated use of forward guidance, and a switch from a corridor to a floor operating system.

One area that has not changed is the Fed's basic operating framework, defined here as the instruments, tools, and targets the Fed uses in its conduct of monetary policy. The Fed's operating framework for the past few decades has been geared toward a positive interest rate environment and an inflation target. (1) This framework has become, however, increasingly strained over the past decade as the secular decline in interest rates has pushed U.S. interest rates closer to zero percent and as the Fed's inflation targeting failed to foster a robust recovery after the Great Recession.

This article makes the case that there is an urgent need to upgrade the Federal Reserve's operating framework to the realities of the 21st century. To do this, the Fed needs to make several important changes. First, it needs to adjust its operating framework so that it is robust to both positive and negative interest rate environments. Second, the Fed needs to tie its operating framework to a level target so that it can do meaningful forward guidance. Finally, the Fed's operating framework needs the enhanced credibility that comes by providing the Fed explicit but constrained access to a standing fiscal facility at the zero lower bound.

This article outlines a proposal that accomplishes this goal and does so in a manner that would encourage the Federal Reserve to act in a more systematic, rules-based, accountable manner. The article motivates this proposal by looking back at two important macroeconomic developments of the past decade and then considers what they mean for the future of U.S. monetary policy. First, it looks at the secular decline in interest rates; then it reviews the accomplishments of the large-scale asset purchase programs, also known as quantitative easing (QE), undertaken by central banks. Both developments suggest that conventional and unconventional monetary policy will have limited effectiveness in the economic environment likely to prevail in the future. Moreover, they indicate that unless significant changes are made to the Federal Reserve's operating framework, U.S. monetary policy will be largely impotent during future recessions.

The Secular Decline of Interest Rates

The first important development that became apparent over the past decade is that interest rates have been on a secular decline. This development has been going on since the 1980s but intensified and became more obvious in the wake of the Great Recession. For some advanced economies like the eurozone, Japan, and Switzerland, this decline has resulted in sustained negative interest rates across much of their yield curves. (2) Other economies, like the United States, which have not yet joined the negative interest rate camp, appear headed in that direction. (3) The top chart of Figure 1 highlights this development for 11 advanced economies: Australia, Canada, the eurozone, Israel, Japan, New Zealand, Norway, Sweden, Switzerland, United Kingdom, and the United States. It shows a GDP-weighted average of each country's 10-year government bond yield. It now sits near 0.5 percent and should hit 0.0 percent in 2022 given its average pace of decline over the past few years.

Some observers attribute this decline to central banks keeping interest rates low, but the next two charts in Figure 1 suggest there are far bigger forces at work. (4) The second chart shows the holders of debt securities issued by advanced economies. It reveals that while central bank holdings have increased because of QE programs in the past decade, there has been a greater and longer change in foreign holdings of advanced economy debt. The third chart shows a consequence of this shift: a rising global saving rate (inverted on the graph) driving down the term premium on government bonds in advanced economies. These last two charts tell a story of global investors increasingly investing their savings in advanced economies and, in turn, driving down their interest rates. This well-documented phenomenon is generally attributed to a global shortage of safe assets (Caballero, Farhi, and Gourinchas 2017; Caballero 2018).

Safe assets are debt instruments that are expected to preserve their value in adverse systemic events. They also provide liquidity services and can be viewed as a form of money. As a result, investors are willing to pay a premium for their "convenience yield" (Krishnamurthy and Vissing-Jorgensen 2012; Gorton 2017). The biggest sources of safe assets are government bonds from advanced economies, especially U.S. Treasuries. The global demand for them has far outstripped their supply, and this has led to the global safe asset shortage problem.

This shortage has arisen and persisted for several reasons. First, globalization has spurred rapid economic growth in emerging markets, but it has not increased their ability to create safe stores of value. Consequently, these countries have turned to advanced economies for safe assets. (5) Second, many parts of the world are aging and, as a result, shifting their portfolios away from riskier assets to safer ones. Third, financial crises starting with the emerging markets in the 1990s and continuing through the global financial crisis of 2008 and the eurozone crisis of 2010-2014 have increased risk aversion and, thereby, further raised demand for safe assets. New financial regulations coming out of these crises have also raised demand for safe assets by financial firms. Finally, the uncertainty surrounding President Trump's trade war has also strengthened demand for safe assets.

Most of these developments are structural and likely to persist. (6) Moreover, they can become self-perpetuating and lead to what Caballero, Farhi, and Gourinchas (2017) call a "safety trap." This problem emerges when the excess demand for safe assets pushes down safe asset yields to the effective lower bound (ELB) on interest rates. If the excess demand for safe assets is not satiated at that point (i.e., the equilibrium real safe asset interest rate is below the ELB), then aggregate demand will contract and push down inflation. Via the Fisher relationship, the lower inflation will drive up the real safe asset interest rate and increase the spread between it and the equilibrium real safe asset interest rate. As a result, aggregated demand will further contract and the cycle will repeat. (7) This is the safety trap.

The safe asset shortage, then, is causing a secular decline in interest rates and, via arbitrage in global capital markets, making it a global phenomenon (Del Negro et al. 2018). This is why the downward march of interest rates is happening to all advanced economies and is putting downward pressure on their yield curves. Some economies, such as Japan, the eurozone, and Switzerland, already have much of their yield curve at negative values. The U.S. economy is not far behind and is likely to see further downward pressure on its yield curve (Tukker 2019).

Large-Scale Asset Purchase Programs

The second big development of the past decade was the use of LSAPs by central banks in advanced economies, beginning with the Federal Reserve in late 2008. These central banks resorted to LSAPs after conventional monetary policy ran up against the ZLB on interest rates. This so-called unconventional monetary policy was used to provide additional stimulus to aggregate demand in the wake of the Great Recession.

The LS AP programs entailed the purchase of long-term securities and were to work through a portfolio balance channel, a signaling channel, and a market calming channel. Long-term interest rates, in turn, would be lowered and spur aggregate demand growth (Gagnon 2016). There is now a fairly large literature that has evaluated the effectiveness of the QE programs and it generally finds they were moderately successful in lowering long-term yields. In the case of the U.S. economy, this literature suggests the LSAP programs lowered the 10-year Treasury yield by just over 100 basis points (Borio and Zabai 2016; Gagnon and Sack 2018; Swanson 2018). (8)

While many agree LSAPs had some influence on long-term interest rates, there is less agreement as to their impact on broader economic activity (Thornton 2015; Bordo and Levin 2019). Here, the empirical findings are mixed and even advocates of QE like Gagnon (2019) acknowledge the recovery that accompanied these programs was weaker than expected. Some attribute the slow recovery to the severity of the 2008-09 financial crisis, but even nominal economic measures like inflation and nominal GDP over which the central banks should have...