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2012 Annual Report

Monetary Policy
Tools Used on
Fed's Balance Sheet

The Federal Reserve's balance sheet was central to monetary policy in 2012 as policymakers sought to boost economic growth and job creation. At the same time, the Fed continued to enhance its communications as a policy tool.

U.S. monetary policy remained extremely accommodative in 2012 as the Federal Open Market Committee (FOMC) continued its aggressive efforts to put some wind in the sails of the recovery. With the federal funds rate near zero for nearly four years, the committee relied heavily on balance sheet tools and other unconventional policies to jump-start growth and ease financial market conditions.

Balance sheet programs in 2012

Two Fed balance sheet measures—the maturity extension program and large-scale asset purchases (LSAP) —were central to the FOMC's monetary policy in 2012. The former, technically referred to as the maturity extension program but popularly known as "Operation Twist," was slated to expire in June. However, the committee decided to extend the program after seeing signs that the economic recovery had lost momentum in the second quarter.

Then in September, the committee announced that it would purchase mortgage-backed securities (MBS) at a pace of $40 billion a month until the outlook for labor markets improved substantially. The Fed's asset purchases are often called quantitative easing, or QE for short. (The most recent round of bond buying is popularly called QE3.) The open-ended nature of the program differs from previous asset purchases, which were bound by either dates or fixed amounts. The FOMC also announced in December that it would replace the expiring maturity extension program with outright purchases of longer-term Treasury securities in the amount of $45 billion a month. The purchases are aimed at lowering longer-term interest rates, boosting asset prices, and supporting economic growth more generally.

See see chart 1 and chart 2 for details on the Federal Reserve's assets and liabilities.

Is it working?

In an August 31 speech, Fed Chairman Ben Bernanke cited several empirical studies that support the view that the Fed's balance sheet measures helped to keep yields on long-term Treasuries, corporate bond rates, and mortgage rates lower than they would have been otherwise. Despite the difficulty in quantifying the effects, the bottom line is this: absent the Federal Reserve's balance sheet policies, U.S. output and job growth would likely have been lower.

QE3 is not QE infinity

The open-ended nature of the latest round of asset purchases does not mean they will continue indefinitely. Indeed, they came with a caveat of sorts. In addition to assessing labor market conditions, the FOMC said that it would also consider the efficacy and costs of additional purchases.

The committee's cost-benefit framework took into consideration several potential risks. For instance, the central bank's large share of Treasury and MBS markets could impair market functioning. In addition, reinforcing low interest rates creates a potential for asset purchases to fuel speculative behavior, with potentially harmful effects on financial stability. Though these sorts of developments represented only potential problems, the committee committed to an ongoing review of both costs and benefits to assess whether to adjust or halt its asset purchase programs.

A conversation about Fed communications

Last year, the FOMC built on its previous efforts to communicate to the public its expectation for the future course of monetary policy. These communications, sometimes called forward guidance, were based on the idea that monetary policy works better if it is well understood. The FOMC felt that this forward guidance adds a level of predictability, which can also help consumers and businesses make better-informed decisions about spending and investment.

Photo of Dave AltigThe FOMC marked an important communication milestone early in the year when it released its first "Statement of Longer-Run Goals and Monetary Policy Strategy." The statement provided a new level of clarity around the committee's interpretation of its dual mandate, which is maximum employment and stable prices. For starters, the statement made explicit what formerly had been an implicit inflation goal of 2 percent. The statement also shed light on committee members' estimates of the longer-term "normal" rate of unemployment, which then ranged from 5.2 to 6 percent.

The committee's communications regarding the future path of the federal funds rate and its large-scale asset purchases (LSAP) also evolved over the course of the year. Back in 2011, the committee had begun communicating a time frame during which it anticipated that extremely low levels for the federal funds rate would be appropriate. Last year, the time frame was extended from late 2014 to mid-2015. In December, the committee provided even more clarity around the future path of the fed funds rate when it said that the benchmark rate would remain near zero as long as:

  • The unemployment rate remains above 6.5 percent.
  • Inflation over a one- to two-year period is projected to be no more than 2.5 percent.
  • Longer-term inflation expectations remain well-anchored.

The FOMC's latest round of bond buying also employed forward guidance, although this guidance is more qualitative than the guidance on the federal funds rate. As mentioned previously, the committee said in September that it would continue its asset purchases until the outlook for labor markets improves substantially. Despite the challenges associated with defining "substantial improvement," this conditionality also provides additional clarity around the committee's intention and expectations for the purchases.