Federal Reserve Chair Janet Yellen delivered testimony on the Semiannual Monetary Policy report to the Senate Banking Committee on Tuesday. Not surprisingly, the hearing focused on the economic outlook, the timing of an increase in the federal funds rate, and financial regulatory policy. But the topic of federal debt did come up, and Yellen corroborated our view on why debt should be put on a downward path.
In response to a question from Sen. Heidi Heitkamp (D-ND) about longer-term challenges facing the economy, Yellen responded that one was "longer-run issues with the federal budget."
I think Congress has made painful decisions that have now really stabilized, brought down the deficit very substantially and stabilized for a number of years the debt-to-GDP ratio. But eventually debt-to-GDP will begin to rise, and deficits will increase again as the population ages and Medicare, Medicaid, and Social Security get to be a larger share of GDP under current programs. And there are lots of ways in which these are problems we've known about for a long time.
The Federal Reserve's efforts to help the economy recover through quantitative easing (QE), twisting, and tapering have made front page news without fail. Although it has gotten less attention, the Treasury Department has also been changing the way it finances the national debt to take advantage of lower interest rates, inadvertently counteracting some of the intended effect of the Fed's policies on the economy. That's exactly what a new Brookings working paper by Robin Greenwood, Samuel Hanson, Joshua Rudolph, and Lawrence Summers argues: during the past 5 years, the Fed and the Treasury have been "rowing in opposite directions."
In 2008, the Fed reduced interest rates to near zero in an attempt to help the economy grow. But nominal interest rates cannot go below zero, so conventional monetary tools stopped working. To further stimulate the economy, the Fed took extraordinary measures and began purchasing long-term government bonds and government guaranteed debt (like Mortgage Backed Securities, or MBS). These measures reduced the amount of long-term debt available for public investors and lowered long-term rates.
But while the Fed was engaging in these unconventional transactions, the Treasury was selling more long-term debt to lengthen the average maturity of the national debt, thereby locking in today's low rates and mitigating the risks of higher interest rates in the future, essentially providing a partial counterbalance to the Fed’s policies.
In a move that has been discussed and anticipated for months, the Federal Reserve's Federal Open Market Committee announced that it would slightly scale back its current quantitative easing program (QE3). Specifically, it would slow its purchases of longer-term Treasury and mortgage-backed securities by $5 billion per month each, reducing the total monthly purchase from $85 billion to $75 billion.
Beginning tomorrow, the Federal Open Market Committee, the Fed's interest rate setting and deliberative body that meets eight times a year -- will meet for two days to make decisions about the future path of U.S. monetary policy. In particular, many are looking to see whether the Fed will begin a "taper" and slow the rate of asset purchases, signaling the beginning of an unwind of the Fed's expanded balance sheet.
This morning, Federal Reserve Chairman Ben Bernanke testified before the Joint Economic Committee regarding the current economic climate. He noted that the economy has begun to show signs of life, attributing the accelerating pace of GDP growth to gradual improvements in credit conditions and the housing market. He also argued that the Fed should continue its quantitative easing at its current pace until the labor market improves sufficiently.
In September, the Federal Open Market Committee (FOMC) announced a third round of quantitative easing, consisting of purchases of mortgage-backed securities and long-term Treasuries. QE3 represented a break from previous rounds of easing because it did not involve an end date for the purchases. With that modification, there was some speculation that the FOMC would also set inflation and unemployment thresholds after which, if reached, the Fed would wind down its easing policy.
Federal Reserve chairman Ben Bernanke held a press conference yesterday following the conclusion of the Federal Open Market Committee meeting. Questions spanned a variety of topics including the Fed's current monetary policy stance, the economic outlook, the possible threat posed by European troubles, and Fed transparency. But one question did come up about the fiscal cliff and how the Fed would react if no action were taken. Here are his remarks: