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Primer on Nontraditional Monetary Policy Tools: The Maturity Extension Program

toolsDuring the recent financial crisis, the Federal Reserve initially employed its traditional monetary policy tools, bringing the federal funds rate target rate down to practically zero by the end of 2008. But once they reached the zero bound, they could not push the rate any lower. The Fed then turned to some less traditional types of tools, including maturity extension and the purchase of mortgage-backed securities (MBS), to improve economic growth and the labor market. Since most textbooks have not yet caught up with these policy instruments, we offer a plain English primer on the art and science of the Fed's recent policy actions, with discussion questions that you can use with your students.

What policy actions did the Fed take recently?
In September 2011, the Federal Open Market Committee (FOMC) announced a $400-billion program to sell, or redeem, short-term Treasury securities and purchase longer term securities with the proceeds. The FOMC later extended this program—officially called a maturity extension program, or MEP, and unofficially known as "Operation Twist"—through the end of 2012.

In September 2012, the Fed increased its accommodative monetary policy stance by increasing its purchases of agency MBS by $40 billion per month while continuing to reinvest the principal payments from existing securities and agency debt holdings into agency MBS. (Agency securities are guaranteed by government-sponsored entities such as Fannie Mae and Freddie Mac.) The FOMC renewed these programs in December, directing the Trading Desk at the New York Fed to purchase $45 billion in longer-term Treasury securities per month and to extend the $40 billion monthly purchase of agency MBS and reinvestment of principal payments. They also announced that in January, the Fed's maturing Treasury securities would be rolled over into new issue at auction and that it would continue its accommodation until the economic recovery is on solid footing and economic conditions warrant a change in direction.

Why did the Fed choose to take these actions?
Congress has given the Federal Reserve the statutory mandate to promote maxiumum employment and price stability. At its December 2012 meeting, the FOMC expressed concerns that the current level of economic growth was not robust enough to bring about an improvement in labor market conditions. Although unemployment had fallen more than 2 percentage points from its 10 percent peak in 2009, it was still above the long-run normal rate and well above its prerecession level. Consumer spending had picked up and housing was showing some signs of improvement, but business investment appeared to be slowing. Furthermore, growth in the gross domestic product (GDP) was averaging just over 2 percent since the recession's mid-2009 trough. The FOMC felt the economy was not expanding as quickly as it had in previous postrecession recoveries.

How long will these programs last?
In an effort to increase transparency and to reduce financial market uncertainty, the FOMC communicates its long-term monetary policy strategy through its press releases, forecasts, and meeting minutes. In 2011, FOMC statements began to include wording about the duration of their accommodative monetary policy stance. In its September 2012 statement, the Committee announced that it expected economic conditions to warrant the federal funds rate to be held around the zero bound until at least the middle of 2015. In the December 2012 statement, the FOMC said that as long as the unemployment rate remains above 6.5 percent and as long as the market's expectations for inflation continue to be close to the Fed's objective of 2 percent, the federal funds rate would likely be sustained in the 0 to ¼ percent range.

How are these actions carried out?
Monetary policy begins when the FOMC directs the open market Trading Desk at the Federal Reserve Bank of New York to conduct purchases or sales of assets such as Treasury securities or MBS. These purchases are conducted through the Fed's primary securities dealers in a competitive bidding process, the results of which, along with technical and pricing details, are published on the New York Fed's website. There are currently 21 primary dealers who assist the Fed in carrying out its monetary policy actions.

To achieve the current goal of purchasing longer-term securities, the Fed has replaced Treasury securities that have maturities of three years or less with securities that mature in six to 30 years. It has also begun purchasing Treasuries, bringing the maturity of the securities in the Fed's portfolio to an average of nine to 10 years.

How do these actions affect the economy?
As Chairman Bernanke explained in his June 2012 press conference, when the Federal Reserve buys MBS, the prices of these securities should increase and their yields (that is, their interest rates) should fall. With longer-term debt off the market, investors are likely to seek other assets. When they replace the MBS that the Fed purchases with other assets such as stocks and corporate bonds, the prices of these assets should also rise while their yields decline. A bank that has sold its Treasury securities may decide to make loans instead, particularly as lower interest rates make lending more profitable relative to holding securities. Lower interest rates encourage businesses to invest in more capital and households to spend more on houses, cars, and other goods and services.

As businesses expand and production increases in response to stronger demand, more hiring should result. In an October 2012 speech to the Economic Club of Indiana, Chairman Bernanke noted that when the Fed first announced its mortgage-backed security purchasing program in late 2008, 30-year mortgage rates averaged a little over 6 percent. Today, they have fallen to around 3.5 percent. These low rates have translated to improvement in the housing market and in the economy in general. Bernanke noted that other interest rates, such as those on corporate bonds and auto loans, have also fallen.

In his 2012 Jackson Hole speech, Bernanke explained that the Fed's nontraditional tools, by lowering longer-term interest rates, work through the same channels as traditional monetary policy and with the same goal: to improve financial conditions and stabilize the economy. As the prices of assets such as homes and stocks rise in response, this increase in wealth promotes an increase in business and consumer spending. He said in his Indiana Economic Club speech that the Fed's actions also serve to signal to the markets the Fed's intentions to maintain an accommodative monetary policy stance, which help to lessen uncertainty and improve consumer and business confidence about the future, resulting in job creation and a more robust economy.

Will these policy actions increase the risk for inflation?
The low interest rates that the Fed has been sustaining for the past five years have not brought about a significant increase in inflation. In fact, since the recovery began about three years ago, inflation has averaged about 2 percent, which is the Fed's target rate. The Fed finances its securities purchases by creating reserves in the banking system, and these increased bank reserves do not necessarily translate into more money or cash in circulation. In fact, broad measures of the money supply have not expanded rapidly over the past few years, despite the Fed's purchases, Bernanke recently explained. Even with a large balance sheet, the Fed has the tools to tighten monetary policy when economic conditions merit doing so. Among these tools is the interest rate that the Fed pays banks on their reserve balances deposited at the Fed. If banks receive a higher interest rate paid on reserves, they may find holding reserves more attractive than lending, which would have the effect of soaking up excess liquidity in the financial markets. 

Discussion questions

  1. What nontraditional tools has the Fed employed recently to promote economic recovery?
  2. What is meant by the term "maturity extension program"?
  3. What economic condition(s) prompted the Fed's recent policy actions?
  4. Who is responsible for carrying out the Fed's asset purchases?
  5. When the Fed purchases mortgage-backed securities (MBS), how does the purchase affect their price and yield?
  6. How do the Fed's purchases of mortgage-backed securities affect the prices and yields of other financial assets?
  7. How do lower interest rates affect the spending decisions of businesses and households?
  8. How have mortgage rates been affected by the Fed's purchase of mortgage-backed securities? How does this affect the overall housing market?
  9. Has the large increase in the Fed's balance sheet in recent years brought about inflation? Why or why not?
  10. Describe at least one tool that the Federal Reserve has in place to use when economic conditions call for tightened monetary policy.

Chairman Bernanke speeches
"Monetary Policy since the Onset of the Crisis," August 31, 2012, Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, WY
"Five Questions about the Federal Reserve and Monetary Policy," October 1, 2012, Economic Club of Indiana

Atlanta Fed President Dennis Lockhart speech
"Fiscal Uncertainty, Monetary Policy, and the Economic Outlook," January 14, 2013, Rotary Club of Atlanta

FOMC press releases, statements, and events
September 21, 2011, press release
June 20, 2012, press release
June 20, 2012, press conference video
September 13, 2012, press release
December 12, 2012, press release
December 12, 2012, statement

Other information
Board of Governors: Maturity Extension Program and Reinvestment Policy
New York Fed: FAQs: Maturity Extension Program
Primary Dealers List

By Lesley Mace, economic and financial education specialist with the Jacksonville Branch of the Federal Reserve Bank of Atlanta

January 30, 2013