Going Negative: The Virtual Fed Funds Rate Target

Balance sheet monetary policy presents what the folks at the Fed call a “communications” problem.

This “communications” problem matters because balance sheet monetary policy is, as it should be, the Fed’s primary tool once the fed funds rate (

the very short-term interest rate at which banks lend to each other overnight

) has already been brought down to essentially zero.

Take what the press called QE2 (Quantitative Easing, Round 2) for example: the Fed announced in November 2010 that it would buy $600 billion dollars worth of long-term government bonds.Because many (though not all) of the households and firms from whom the Fed bought these long-term government bonds were reasonably content to switch into holding short-term government bonds or close substitutes to cash instead, much of the effect of the $600 billion dollar purchase was neutralized and QE2 had more or less the modest positive effect that the Fed had expected it to have.As I discussed in my post “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy,” large headline numbers for asset purchases, associated with modest effects, are typical of balance sheet monetary policy.Aside from“communications,” this is not a serious difficulty for monetary policy, since the Fed is perfectly capable of printing money and purchasing trillions of dollars worth of assets if it needs to.And it is perfectly capable of focusing its purchases on assets with interest rates that are still above zero and can be pulled down closer to zero. But the public can be forgiven for getting scared when it sees massive asset purchases and only modest effects.

So what should the Fed do?I know this is an area where the Fed will carefully listen to and at least consider advice, so I feel a duty to do my best to come up with a constructive suggestion before tomorrow’s monetary policy setting meeting of the Federal Open Market Committee (FOMC).  Because my suggestion is very specific, in the rest of this post, I will use the more precise “FOMC” instead of its approximate synonym “the Fed” that I have used when talking about monetary policy in other posts.  Let me first say what I think the FOMC shouldn’t do in communicating balance sheet monetary policy intentions.  Here is what the FOMC said in its official statement in November 2010:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.

This FOMC statement led to front page newspaper articles prominently featuring the $600 billion figure. Later on, newspaper articles appeared saying that the Fed had done this large amount of asset purchases with little subsequent effect.  So I worry that having the large dollar figure in people’s minds causes many to doubt the efficacy of balance sheet monetary policy–something that I think is dangerous given the importance of expectations and confidence.  Highlighting the large dollar figure for asset purchases also causes others, including those in high places, to think that the Fed is doing too much, despite the action having only modest aggregate demand effects. I worry that facing such ill-informed criticism could lead the FOMC to do less than it would otherwise judge that it should. 

So what can be done instead to accurately convey the FOMC’s intentions?  Since balance sheet monetary policy leads to relatively modest interest rate movements for a given amount of asset purchases, my argument is that it would give the public a more accurate idea of the Fed’s intended effects if the FOMC’s decision could be stated in interest rate terms rather than in terms of asset quantities.  That is what the FOMC usually does in normal times when the fed funds rate is above zero: it announces how much it is going to raise or lower the fed funds rate. The way the fed funds rate is raised or lowered in normal times is primarily by having the New York Federal Reserve Bank sell or buy some quantity of 3-month Treasury bills.  But the quantity of 3-month Treasury bills the New York Fed is going to sell or buy is not emphasized.   

One could imagine having the FOMC statement focus on some other particular interest rate, say the rate on 2-year Treasury notes.  But this faces two related objections.   As I pointed out in my post “Balance Sheet Monetary Policy: A Primer”:

It is logically possible that sellers might sell all of a particular asset to   the Fed before its interest rate gets down to zero.

This logical possibility is most likely to actually occur for something such as 2-year Treasury notes that have many very close substitutes.  (For example, among the many close substitutes for the newly issued 2-year Treasury notes that define the 2-year interest rate are the 2-year Treasury notes issued last month, which now have a remaining maturity of 23 months.)  This presents two problems.  First, since people are worried about the Fed “monetizing the debt”–that is, taking on the inherently inflationary role of trying to fund the Federal Government–it creates another type of “communications” problem if the Fed owns all of the Federal Government’s debt, even if only at one specific maturity.  The second problem is that the New York Fed may not be able to meet a specific interest rate target on that particular asset, since it may have purchased all of the asset before that interest rate target is reached.  And it is a very big communications problem if the New York Fed can’t do what the FOMC says it is going to do.  This would hurt the credibility of the FOMC, which is its most precious asset. 

What I propose is that the FOMC say something like this when it feels that monetary policy should be more expansionary than a fed funds rate of zero alone will provide:

In addition to keeping the federal funds rate at 0 to ¼ percent, the Committee will undertake purchases of other securities in amounts estimated to provide an effect on aggregate demand equivalent to what a reduction in the federal funds rate target of 2 percent would normally provide.  

(Of course, they should substitute the correct number where I have put “2%.”) This could be followed by some guidance about what mix of asset purchases would be involved–say 50% long-term government bonds, 50% Fannie Mae securities–without saying exactly what quantities would be purchased.  The financial markets and the press would eventually figure out what kinds of quantities were involved, but these numbers would be more likely to be reported in the middle of a newspaper article, and might not even make it to the front page. 

The “virtual fed funds rate target” of my title is my suggestion for how the press could report this action by the FOMC:

The Federal Reserve today set a virtual fed funds rate target of -2%.  Since the fed funds rate is already close to zero, the Fed is slated to buy various assets (including long-term government bonds and mortgage-backed securities from Fannie Mae) in order to achieve the same stimulus that reducing the fed funds rate by 2% normally would accomplish. 

And here is the headline:


To me, this sounds much less inflammatory than


Another plus. In addition to the advantages I have emphasized of avoiding misunderstanding by the public, the virtual fed funds rate target will also help avoid another type of misunderstanding by those who watch monetary policy closely.  In its most recent statement, the FOMC said 

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

In saying that the federal funds rate is likely to stay low through late 2014, I think the FOMC is simply informing people about its thinking by making a prediction about what it is going to do in the future, emphasizing that what it will actually do depends on future conditions.  But despite the clarity of its words, some people read into this something more: they think the FOMC is saying that it is promising to keep the fed funds rate in the future lower than it otherwise would in order to stimulate the economy now.  The reason they think this is that in formal models that exhibit Wallace neutrality,  the only way to get more oomph from monetary policy once the fed funds rate is at zero is by promising to overstimulate the economy in the future when the fed funds rate will no longer be at zero. (On Wallace neutrality, see my crowd-sourcing post “Is Monetary Policy Thinking in Thrall to Wallace Neutrality?” and its comment thread, as well as “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy,” and Noah Smith’s post “Does Steve Williamson Think Printing Money Can’t Cause Inflation?”)  I will save for another post a rundown of some of those (especially those in the blogosphere) who believe in the implication of Wallace neutrality that I have bolded and italicized above.  For now I simply want to recommend that the FOMC distance itself from this view.  If the FOMC believes that balance sheet monetary policy works, as I think it does, there is no need to promise to overstimulate the economy in the future (when the fed funds rate is above zero) in order to stimulate it now (when the fed funds rate is zero).  And even more, I hope that the FOMC doesn’t in the future feel that it has made such a promise to overstimulate the economy that it must then follow through on.

The beauty of the virtual fed funds rate target is that it communicates the idea that it is likely to be a while before the FOMC raises the fed funds rate above zero without any danger of being misconstrued as a promise.  It is natural for the fed funds rate target–including the virtual fed funds rate target–to evolve gradually over time as information about the state of the economy comes in.  (More on that in a future post.)  If, say, the virtual fed funds rate target were currently at -2%, it would be a reasonable inference that the fed funds rate target was not likely to get above zero for some time, unless there was dramatic new information about economic activity or inflation.  So the virtual funds rate target communicates the likelihood that a near-zero fed funds rate is likely to continue for some time, without any appearance of tying the FOMC’s hands. 

Of all the policy proposals I have made so far in this blog, this is the only one that I think can be implemented immediately.  There is no reason the FOMC couldn’t use this idea in its statement tomorrow or Wednesday.  I strongly urge any of the Federal Reserve System’s staff economists who read this post and agree with this idea, or who simply think it deserves consideration, to forward a link to others in the Federal Reserve System–and of course to take advantage of opportunities to communicate this idea to members of the FOMC itself.