Measuring the Fed's Monetary Policy Stance during COVID-19

Rudebusch, “Interest Rates Under Falling Stars,” American Economic Review, Vol. 110, No. 5, May 2020. The output gap is the difference, in ... Home> Publications> RegionalEconomist> MeasuringtheFed’sMonetaryPolicyStanceduringCOVID-19 April14,2022 By  WilliamR.Emmons KEYTAKEAWAYS TheadditionofbondpurchasesandforwardguidancetotheFed’straditionalshort-terminterestrateinstrumentsuggeststheneedforanew,combinedmeasureofmonetarypolicysettings. Monetarypolicy’simpactontheeconomywilldependonboththeFed’sinstrumentsettingsandontheeconomy’scurrentcondition. TheCOVID-19periodillustrateshowimportantitistoconsiderbothfactors(instrumentsettingsandeconomicwindspeed)whengaugingthestanceofmonetarypolicy. TheFederalReserveActinstructstheFederalReservetousemonetarypolicytopromotemaximumemployment,stablepricesandmoderatelong-terminterestrates.SeeSection2A,"MonetaryPolicyObjectives,"intheFederalReserveAct.Inpractice,theFed“leansagainsttheeconomicwind,”tighteningpolicywheninflationthreatenstheeconomyandeasingpolicywhentheeconomyweakens.Thisarticleexplainsonewaytogaugethestanceofmonetarypolicy;thatis,howtomeasuretheFed’sinstrumentsettingsinlightoftheeconomicwind. MeasuringMonetaryPolicySettings Since2008,theFedhasconductedmonetarypolicyusingbothconventionalandunconventionaltools.See“PolicyTools.”Managingshort-terminterestratesservesastheFed’skeyconventionaltoolwhilepurchasinglonger-termbondsandforwardguidancehavebeenitsmainunconventionaltools. WhentheFedisimplementingconventionalpolicy,analystscommonlyusethelevelofshort-terminterestratesto(crudely)measurethestanceofpolicy.Highshort-terminterestratestendtocontracteconomicactivitywhilelowshort-terminterestratestendtodotheopposite. Whileshort-terminterestratescontrolledbytheFedcontinuetoserveasanimportantmeasureofmonetarypolicy,See“MonetaryPolicyPrinciplesandPractice.”extendedspellsattheeffectivelowerboundofinterestrates,combinedwithnewmonetarypolicytools,meanthatweneedasummarymeasureofmonetarypolicy’scombinedsettingstogaugethestanceofpolicy.ThelowerlimitofthefederalfundsratetargetrangewaszerobetweenDec.16,2008,andDec.16,2015,andagainbetweenMarch16,2020,andMarch16,2022. Onesuchmeasureofmonetarypolicyisthe“shadow”federalfundsrate.SeeJingCynthiaWuandFanDoraXia,“MeasuringtheMacroeconomicImpactofMonetaryPolicyattheZeroLowerBound,”JournalofMoney,CreditandBanking,Vol.48,Nos.2-3,March-April2016.SeetheAtlantaFedformoreexplanationandthecurrentshadowrate.Basedonamodelofinterestratesofmanymaturities,theshadowrateisanestimateofwhattheFed’sovernightinterestratewouldbeiftheFOMCextendeditspolicyrangebelowzero,whichitcurrentlydoesnotdo.ThiscaptureshowtheFed’snon-interestratetools,includinglarge-scaleassetpurchasesandforwardguidance,affectthecurrentandexpectedfuturepathofthefederalfundsrate. Yettheneutrallevelofthefederalfundsrate—onethatcannotbecharacterizedaseithertightorloose—changesovertime.Thus,whetheragiveninterestratelevelstimulatesorcontractseconomicactivitydependsonitsrelationtothismovingtarget. Oneapproachtoestimatingthelong-termneutralrateistolookforanindicatorinfinancialmarketsthatsuggestswhattheshort-termratewillbefarinthefuture,afteranycurrenteconomicsquallshavepassed.SeeMichaelD.BauerandGlennD.Rudebusch,“InterestRatesUnderFallingStars,”AmericanEconomicReview,Vol.110,No.5,May2020.Along-termTreasuryforwardrateispreciselysuchanindicator:Itisrelatedtotheshort-terminterestrateexpectedtoprevailataparticulardateinthefuture,derivedfrommarketpricestoday. Comparingthefederalfundsrateorashadowfederalfundsratetoalong-termTreasuryforwardratethereforeallowsustocharacterizethedegreeoftightnessoreasetheFedisapplyingtotheeconomyifoneassumescurrentconditionsareaverageornormal.But,ofcourse,currentconditionsmaynotbeaverage,asthenextsectionexplores.ThefigurebelowshowshowthismeasureoftheFed’smonetarypolicysettingshasvariedeachmonthbetweenDecember1971andDecember2021. AMeasureofMonetaryPolicySettings:FederalFundsorShadowRateMinusNeutralRate SOURCES:FederalReserveBoard,FederalReserveBankofAtlantaandauthor’scalculations. NOTES:ThefigureshowsamonthlymeasureoftheFed’smonetarypolicysettingsbetweenDecember1971andDecember2021.Thelineshowsthedifferencebetweenthefederalfundsrate,whenthelowerlimitoftheFed’stargetrangeisabovezero,andthe15-yearTreasuryforwardrate,whichservesasaproxyfortheneutralrate.Theshadowfederalfundsrateissubstitutedforthefederalfundsratewhenthelowerlimitofthefederalfundstargetrangeequalszero.Inthefigure,upwardmovementsindicatetighteningofmonetarypolicy,whiledownwardmovementsindicateeasingofpolicy.Tighterpolicyisexpectedtoslowtheeconomywhileeasierpolicyisexpectedtostrengthentheeconomy. MeasuringtheStrengthoftheEconomy TheimpactofmonetarypolicyontheeconomydependsbothonhowtightoreasytheFed’spolicysettingsareatanytime(asshowninthefigureabove)andontheeconomy’scondition.Iftheeconomyisveryweak—forexample,withtheunemploymentrateindouble-digits—thenanaccommodativemonetarypolicyislikelytobeappropriate,withthefederalfunds(orshadow)ratewellbelowtheneutralrate.TheFed’slean-against-the-windpolicyattemptstocounteracttheeconomy’sweakness.Iftheeconomyisverystrong—forexample,withaverylowunemploymentrateandrisinginflation—theFedislikelytosetthefederalfundsratecloserto,orevenabove,theneutralrate. ThefigurebelowcomparesthesummarymeasureofFedpolicydescribedabovetotheoutputgap,i.e.,thestrengthoftheeconomy.Theoutputgapisthedifference,inpercent,betweenthecurrentactualandthecurrenthypotheticalfull-employmentlevelofoutput.Seethesection“BudgetandEconomicData”ontheCongressionalBudgetOffice’swebsiteforanexplanationofpotentialrealGDPandtheoutputgap.TheFed’smonetarypolicysettingstrackthestateoftheeconomy.Whentheoutputgapispositive—whichoccursnearbusiness-cyclepeaks—theFedrunsatightermonetarypolicy.Conversely,whentheoutputgapisnegative—whentheeconomyisinorrecoveringfromarecession—theFedsetsaloosermonetarypolicy.Again,thisishowtheFedleansagainsttheeconomicwind:Thecentralbankexertsrestraintwhentheeconomyisverystrongandprovidessupportwhenitisveryweak. AMeasureofMonetaryPolicySettingsandtheEconomy’sOutputGap SOURCES:FederalReserveBoard,FederalReserveBankofAtlanta,CongressionalBudgetOfficeandauthor’scalculations. NOTES:ThefigureshowsaquarterlymeasureoftheFed’smonetarypolicysettingsbetweenthefirstquarterof1972andthefourthquarterof2021andtheCBO’sestimateoftheeconomy’soutputgapbetweenthefirstquarterof1970andthefourthquarterof2021,alongwithCBOprojectionsforthesubsequentdecade.ThemeasureoftheFed’smonetarypolicysettingsisexplainedinthenotestothefirstfigure.TheoutputgapisthepercentagedifferencebetweenactualrealGDPandtheCBO’sestimateofpotentialrealGDP. CombiningtheFed’sInstrumentSettingsandtheEconomicWindspeed:TheStanceofMonetaryPolicy ThefigurebelowcharacterizesthestanceofFedmonetarypolicysincethebeginningof1972.Thelinerepresentsthedifferencebetweenthemonetarypolicysettingsandtheeconomy’soutputgapataquarterlyfrequency.Forexample: Whenthestanceiszero,monetarypolicyapproximatelyoffsetstheeconomy’sstrengthorweakness. Whenthestanceispositive,monetarypolicyisrestrictiveortight,withthedegreeofrestraintexceedingthestrengthoftheeconomy. Whenthestanceisnegative,monetarypolicyisaccommodativeoreasy,withthedegreeofeaseexceedingtheweaknessoftheeconomy. TheStanceofMonetaryPolicy:Fed’sInstrumentSettingsRelativetoEconomicConditions SOURCES:Seefiguresabovefordatasources. NOTES:Thefigureshowsthequarterlydifferencebetweenthemeasureofmonetarypolicysettingsdescribedinthetextandtheeconomy’soutputgapbetweenthefirstquarterof1972andthefourthquarterof2021.Thelinerepresentsthestanceofmonetarypolicy,whichcombinesthesettingsofmonetarypolicyandthestrengthoftheeconomy.Upwardmovementsinthefigurerepresentatighterstanceofpolicy,whiledownwardmovementsrepresentalooserstanceofpolicy. TheStanceofMonetaryPolicyHasFluctuatedSignificantlyduringthePandemic Accordingtothemeasureinthefigure,themostrestrictivestanceofmonetarypolicyinthelast50yearsoccurredinthesecondquarterof2020,whentheCOVID-19crisishaditsmaximumimpact.Theeconomywasveryweak,withrealGDPsome10.5%belowitspotential.AlthoughtheFedeasedmonetarypolicyaggressivelyusingseveralofitstools,itwasnotenoughtocounteracttheeconomy’sweakness. Conversely,oneofthemostaccommodativestancesofmonetarypolicysince1972occurredinthefourthquarterof2021.AccordingtotheCongressionalBudgetOffice’sestimate,theeconomyhadcompletelyrecoveredbythethirdquarterof2021,andwas1.4%aboveitspotentialinthefourthquarterofthatyear.Monetarypolicysettings,meanwhile,remainedrelativelyeasy. TheCOVID-19periodillustrateshowimportantitistomeasureboththeFed’smonetarypolicysettingsandtheeconomy’scurrentconditiontogaugethestanceofmonetarypolicy.EventhoughtheFeddidnotchangeitstargetrangeforthefederalfundsratebetweenmid-March2020andmid-March2022,theultimateimpactofmonetarypolicyontheeconomyfluctuateddramatically.Thus,it’simportanttogaugemonetarypolicyagainstthestrengthoftheeconomyandadjustaccordingly. Endnotes SeeSection2A,"MonetaryPolicyObjectives,"intheFederalReserveAct. See“PolicyTools.” See“MonetaryPolicyPrinciplesandPractice.” ThelowerlimitofthefederalfundsratetargetrangewaszerobetweenDec.16,2008,andDec.16,2015,andagainbetweenMarch16,2020,andMarch16,2022. SeeJingCynthiaWuandFanDoraXia,“MeasuringtheMacroeconomicImpactofMonetaryPolicyattheZeroLowerBound,”JournalofMoney,CreditandBanking,Vol.48,Nos.2-3,March-April2016.SeetheAtlantaFedformoreexplanationandthecurrentshadowrate. SeeMichaelD.BauerandGlennD.Rudebusch,“InterestRatesUnderFallingStars,”AmericanEconomicReview,Vol.110,No.5,May2020. Theoutputgapisthedifference,inpercent,betweenthecurrentactualandthecurrenthypotheticalfull-employmentlevelofoutput.Seethesection“BudgetandEconomicData”ontheCongressionalBudgetOffice’swebsiteforanexplanationofpotentialrealGDPandtheoutputgap. AbouttheAuthor WilliamR.Emmons BillEmmonsisanassistantvicepresidentandleadeconomistintheSupervisionDivisionattheFederalReserveBankofSt.Louis.Readmoreabouttheauthorandhiswork. WilliamR.Emmons BillEmmonsisanassistantvicepresidentandleadeconomistintheSupervisionDivisionattheFederalReserveBankofSt.Louis.Readmoreabouttheauthorandhiswork. SubscribetoRegionalEconomist TheRegionalEconomistaddressestheregional,nationalandinternationaleconomicissuesoftheday.ViewsexpressedarenotnecessarilythoseoftheSt.LouisFedorFederalReserveSystem. EmailUs Mediaquestions