The Federal Reserve Decision We will pause to consider the Fed’s announcements last week. It is an important new development We will return to Fed policies later, but this is a good introduction. 1

Origins of the Great Recession ( ) Recession turned sharply downward after the peak of the financial crisis in the fall of Output fell and unemployment rose sharply. The unemployment rate has stagnated at 8+% since then. Fiscal policy is paralyzed in the political wars Monetary policy has taken many steps to stimulate the economy (we will discuss these later). Fed has become increasingly concerned that the economy has stagnated 2

Real GDP over the cycle 3 Large GDP “gap”

4 Unemployment rate over the cycle: Shaded areas are NBER recessions.

5 Time for an elevator quiz

Elevator question What are the innovative elements or new policies announced by the Fed in its September 2012 statement? 5 minutes, but at most ½ page. 6

Federal Reserve, Federal Open Market Committee Release Date: September 13, 2012 … Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions…. To support a stronger economic recovery…, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage- backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June. … If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability…. To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid

Answers First point to emphasize is that standard tool (short-term interest rate or federal funds rate) can not effectively be lowered. 8

Federal Reserve, Federal Open Market Committee Release Date: September 13, 2012 … Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions…. 9 Fed has dual mandate. Fed is now emphasizing “real” rather than “inflation” objective. Major movement away from proposal to target inflation (ECB and many inflation hawks.

To support a stronger economic recovery…, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. 10 This is “quantitative easing.” Idea is to purchase long-term securities to lower long-term interest rates. Also, move to mortgage-backed securities to help housing market and lower risk-premium on non- Treasury securities.

The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June. … 11 More steps to length maturity of Fed’s holdings and push down long-term interest rates.

Term structure of Treasury interest rates 12

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability…. 13 Points to objective of reducing unemployment as guideline to policy. Open ended. Earlier policies were time or $ limited.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid Statement that would not raise rates as soon as there is recovery, but implicitly until close to full employment. For at least three years!

Unemployment projections of members of the FOMC 15

Summary Fed has taken an important step in making a commitment to keep stimulating the economy until on a trajectory toward full employment. But does not expect full employment until after