Youll sometimes hear people assigning a liberal slant to quantitative easingbut it was actually proposed by Milton Friedman. In 2000, he was asked what more the Bank of Japan could do to combat deflation, since they were constrained by the zero lower bound. Friedman said, Its very simple. They can buy long-term government securities. Which is exactly what the Fed has been doing.

At this point, it would take a substantial shift in the economic outlook to derail the tapering process.

I say this a lot, because its an important message to get across: The taper does not reflect a tightening of monetary policy. Were not putting out the fire, were just gradually adding less and less fuel. Its just one small step towards policy normalization, when the economy has sufficient heat on its own. A real tightening of policywhich would mean raising the fed funds rateis still a good way off.

Central banks, in turn, may want to build on some recent experience, adapted for more normal times, in addressing the desire to contain systemic risk without removing monetary policy accommodation to advance one or both dual mandate goals.
One example would be altering the composition of a central bank's balance sheet so as to add a second policy instrument to changes in the targeted interest rate. The central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones.

"The metrics of market valuations seem to be broadly within historical ranges," Mr. Bernanke said at an event hosted by the Hutchins Center on Fiscal and Monetary Policy. "The financial system is strong. The key financial institutions are well-capitalized." ... San Francisco Fed President John Williams, also speaking at the Hutchins event Thursday, said while the Fed's bond-buying programs clearly have lowered long-term borrowing rates, a lot of uncertainty remains about how they work, how much they help the economy and what their unintended consequences may be. Mr. Bernanke, however, said financial instability was the only potential risk from the bond-buying program "that I find personally credible, frankly."

"Should large-scale asset purchases be a standard tool of monetary policy at the [zero-lower bound], and, if so, how should they be implemented?" Mr. Williams asked in the paper, which he was scheduled to present and discuss Thursday at an event organized by the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, a Washington think tank.

He said this and other questions need more study because being stuck at the so-called zero-lower bound is a serious problem that policymakers are likely to confront again.

You know, a lot of people say, this [asset buying] is just helping rich people. But it's not true. Our policy is aimed at holding down long-term interest rates, which supports the recovery by encouraging spending. And part of the [economic stimulus] comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy.

And so I do want to reiterate that this is not intended to be a tightening. We don't think that there's an inflation problem or anything like that. On the one hand, asset purchases are still going to be continuing. We're still going to be building our balance sheet. The total amount of assets that we acquire are probably more than was -- certainly more than was expected in September 2012 or in June 2013. So we'll have a very substantial balance sheet, which we'll continue to hold.

So there are a number of reasons why asset purchases, while effective, while I think they have been important, are less -- less attractive tools than traditional interest rate policy. And that's the reason why we've relied primarily on interest rates, but used asset purchases as a supplement when we've needed it to keep forward progress. I think that, you know, obviously, there are some financial stability issues involved there. We look at the possibility that asset purchases have led to bubbly pricing in certain markets or in excessive leverage or excessive risk-taking. We don't think that that's happened to an extent, which is a danger to the system, except other than that, when those positions unwind, like we saw over the summer, they can create some bumpiness in -- in interest rate markets, in particular. Our general philosophy on financial stability issues is, where we can, that we try to address it first and foremost by making sure that the banking system and the financial system are as strong as possible -- if banks have a lot of capital, they can withstand losses, for example -- and by using whatever other tools we have to try to avoid bubbles or other kinds of financial risks. That being said, I don't think that you can completely ignore financial stability concerns in monetary policy, because we can't control them perfectly and there may be situations when financial instability has implications for our mandate, which is jobs and inflation, which we saw, of course, in the Great Recession. So it's a very complex issue. I think it will be many years before central banks have completely worked out exactly how best to deal with financial instability questions. Certainly, the first line of defense for us is regulatory and other types of measures, but we do have to pay some attention to that.

We should be clear that an interest rate near zero does not mean the Fed is paralyzed. By purchasing assets, we can increase the supply of monetary assets to the banking system, which in some circumstances can have a stimulative effect. The Fed has purchased significant quantities of assets since the end of 2008. The size of our balance sheet has gone from $2.2 trillion to around $3.9 trillion, and it continues to increase by about $85 billion per month.


The key issue, in my view, is the extent to which the benefits of further monetary stimulus are likely to outweigh the costs. Economic growth trends currently appear to be driven mainly by population growth and productivity growth, in which case monetary stimulus will only have limited and transitory effects. But further stimulus does increase the size of our balance sheet and correspondingly increases the risks associated with the "exit process" when it becomes time to withdraw stimulus. This is why I have not been in favor of the current asset purchase program.

Between November 2008 and June 2012, the FOMC announced or extended a series of asset purchase programs, in each case specifying the expected quantities of assets to be acquired under the program. Like the use of date-based forward guidance, announcing a program of predetermined size and duration has advantages and disadvantages. On the one hand, a fixed program size is straightforward to communicate; on the other hand, a program of fixed size cannot so easily adapt to changes in the economic outlook and the consequent changes in the need for policy accommodation. In announcing its fixed-size programs, the FOMC did state a general willingness to do more if needed--and, indeed, it has followed through on that promise--but such statements left considerable uncertainty regarding the conditions that might warrant changes in an existing program or the introduction of a new one.

In a step roughly analogous to the shift from date-based guidance to the contingent, thresholds-based guidance now in use for the federal funds rate target, in September 2012 the FOMC announced a program of asset purchases in which the total size of the purchase program would not be fixed in advance but instead would be linked to the Committee's economic objectives.

What do these asset purchases accomplish? Well, no surprise here, theoretical economists are of two minds on this issue. In a textbook world of perfect-functioning financial markets, LSAPs would have essentially no effect, positive or negative. According to this theory, the price of an asset depends solely on its expected future returns, adjusted for risk. Investors bid prices up and down so that risk-adjusted returns of different kinds of assets are equal. If the price of a specific asset deviated from this level, arbitrageurs would swoop in to take advantage of the discrepancy, knowing that the price would inevitably return to its proper level. So, under these assumptions, since asset purchases by the Fed don’t fundamentally change the risk-adjusted returns to assets, they wouldn’t do anything to asset prices or the economy more broadly.

In reality, financial markets don’t work nearly so seamlessly, which creates a potential role for asset purchases to have meaningful effects on the economy. Long ago, future Nobel laureates James Tobin and Franco Modigliani argued that certain financial markets are segmented. Some investors, such as pension funds, have strong preferences or even legal restrictions on where they put their money. Such “preferred habitats” for certain types of investments can interfere with the equalization of risk-adjusted returns to different assets…

Now, if the Fed buys significant quantities of longer-term Treasury or mortgage-backed securities, then the supply of those securities available to the public declines. As supply falls, the prices of those securities rise, and the yields on these assets decline. The effects extend to yields on other longer-term securities. Mortgage rates and corporate bond yields fall as investors who sold securities to the Fed invest that money elsewhere. Hence, our asset purchases drive down a broad range of longer-term borrowing rates. And those lower long-term interest rates stimulate the auto market, the housing market, business investment, and other types of economic activity.

I expect that the explicit link between future policy actions and specific numerical thresholds, as in the recent FOMC statements, will not be a regular aspect of forward guidance, at least when the federal funds rate is not constrained by the zero lower bound. This guidance has proven to be a powerful tool in current circumstances, when conventional policy stimulus has been limited by the zero lower bound. But such communication is difficult to get right and comes with the risk of oversimplifying and confusing rather than adding clarity. Therefore, in normal times, a more nuanced approach to policy communication will likely be warranted. I see forward guidance typically being of a more qualitative nature, highlighting the key economic factors that affect future policy actions. Of course, if we again find ourselves in a situation where conventional policy has been fully utilized, then we will have the ability to return to more explicit forward policy guidance to provide additional monetary stimulus.

We should, however, only resort to asset purchases as a policy tool in special circumstances, such as when the federal funds rate is near zero and we have fully utilized forward policy guidance. Despite all that we’ve learned, the effects of asset purchases are much less well understood and are much more uncertain and harder to predict than for conventional monetary policy. Indeed, the recent outsize movements in bond rates in response to Fed communications about our current asset purchase program illustrate the difficulty in gauging the effects of asset purchases. Moreover, given our limited experience, we can’t be sure of all their consequences, which may play out over many years. When the federal funds rate was at zero and we were still facing a severe recession, it was the right call to turn to asset purchases. But, once the federal funds rate is back to a more normal level, we should relegate asset purchases to a backup role, employing it only when conventional policy and forward guidance fall short.

An alternative hypothesis is that our policies were indeed responsible for the very low level of long-term rates, but in part through a more indirect channel. According to this view, real and nominal term premiums were low not just because we were buying long-term bonds, but because our policies induced an outward shift in the demand curve of other investors, which led them to do more buying on our behalf--because we both gave them an incentive to reach for yield, and at the same time provided a set of implicit assurances that tamped down volatility and made it feel safer to lever aggressively in pursuit of that extra yield. In the spirit of my earlier comments, let's call this the "Fed recruitment" view.

I take the events of the past few months to be evidence in favor of the recruitment view…

Again, the existence of this recruitment channel is helpful; without it, I suspect that our policies would have considerably less potency and, therefore, less ability to provide needed support to the real economy. At the same time, an understanding of this channel highlights the uncertainties that inevitably accompany it. If the Fed's control of long-term rates depends in substantial part on the induced buying and selling behavior of other investors, our grip on the steering wheel is not as tight as it otherwise might be. Even if we make only small changes to the policy parameters that we control directly, long-term rates can be substantially more volatile. And if we push the recruits very hard--as we arguably have over the past year or so--it is probably more likely that we are going to see a change in their behavior and hence a sharp movement in rates at some point. Thus, if it is a goal of policy to push term premiums far down into negative territory, one should be prepared to accept that this approach may bring with it an elevated conditional volatility of rates and spreads.

These lending operations changed the composition of the Fed's asset portfolio without changing the Fed's monetary liabilities, and thus constituted "credit policy," not monetary policy.4 Such lending raises important issues related to the independence of central banks and their role in the financial system.5 I have spoken at length about these issues on other occasions, but they are not my focus today.6

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When a central bank uses its independent balance sheet to choose among private sector assets, it invites special pleading from interest groups and risks entanglement in distributional politics. Similar political risks face a central bank, such as the European Central Bank, allocating investments across multiple sovereign debt issuers.

Political pressure to channel credit to favored sectors is not without precedent in the United States. Congress gave the Fed authority to buy the debt of U.S. agencies such as the housing government-sponsored enterprises in 1966 in response to the "credit crunch" that year that reduced flows to housing finance… In 1971, the FOMC relented and began outright purchases of the debt of the housing government-sponsored enterprises.12 (By 1981, purchases had stopped, and the Fed's holdings ran off gradually over the 1980s and 1990s. Outright purchases of agency securities were not conducted again until early 2009.)

How central banks manage the political risks associated with forays into credit policy may prove pivotal for the evolution of central banking in advanced economies. A central bank's core responsibility revolves around its liabilities — that is, the monetary assets it uniquely supplies. Being organized as distinct, off-budget intermediaries, however, requires them to hold assets, and just what assets the central bank should hold has been something of a conundrum…

Of the risks associated with unconventional monetary policies, those associated with central bank holdings of unconventional asset classes may be the most consequential. Violating the implied truce under which central banks avoid credit policy has the capacity to perturb the delicate governance equilibrium supporting the independent conduct of monetary policy. History provides numerous examples of compromised central bank independence leading to calamitous monetary policy.

Well, some days I wish that questions like these {about tapering} could be answered with a firm date, a single number and a confident “yes,” accompanied by a fist pump. Unfortunately, the answer to the first question is not as simple as giving a calendar date. Instead, uncertainty over the pace of the recovery means all of this depends on the progress that the economy makes toward our goals of maximum employment and price stability. In my view, this means continuing our current QE3 asset purchase program until three conditions are met. First, the unemployment rate must be in the vicinity of 7 percent with expectations for it to continue falling in a self-sustaining fashion. Second, other important labor market indicators must show a commensurate improvement. And third, we must have considerable confidence that inflation is moving back toward our target of 2 percent. Currently, my best assessment is that by the time these conditions have been met, our QE3 asset purchases since January of this year will total at least $1.25 trillion. By comparison, that would be twice the size of our QE2 purchases made in 2010 and 2011. This would mean that our System Open Market Account (SOMA) balance sheet will reach approximately $4 trillion.