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Policy Innovations at the Zero Lower Bound

The late summer and early fall bore witness to two new innovations in monetary policy.

The first was at the August Federal Open Market Committee (FOMC) meeting, when the Committee introduced a change to the statement released after meetings, which altered the projected path of the federal funds rate target. The Committee announced that it "currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

The second came in September, when the Committee opted to begin selling shorter-term Treasuries from the Fed's portfolio and use the proceeds from those sales to purchase longer-term Treasury securities. According to the statement, "this should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative."

Both of these innovative moves were intended to adjust interest rates, one through communications and one through balance sheet manipulations. Here's a quick look at how they did and at what some of the consequences could be.

The new language introduced in August is clearly a conditional statement. Whether the federal funds rate stays "exceptionally low" until mid-2013 depends on the economy progressing as the FOMC thinks it will. The August communication strategy, as we've highlighted before, was extremely effective at lowering expected future interest rates. One way of seeing how markets interpreted this statement is by looking at a type of derivative called a federal funds rate future contract. The contract allows banks to borrow interbank (federal) funds at a specified rate at some date in the future. Implied interest rates from these contracts declined dramatically after the August statement, incorporating the expectation that the federal funds rate would remain low until the middle of 2013.

Figure 1. Federal Funds Futures Implied Interest Rates

The announcement of September's new policy, dubbed Operation Twist, was also successful at lowering long-term interest rates. A simple chart of some longer-maturity Treasury yields shows that there were significant declines following the release of the Committee's statement. Yields on 30-year Treasury securities fell 17 basis points to 3.03 percent, and 10-year Treasury yields dropped 23 basis points in the two days following the meeting.

Figure 2. Long-term Treasury Interest Rates

One issue that some economists are concerned about is Operation Twist's effect on the Fed's balance sheet. The policy will likely push the balance of Treasury holdings to long-term security holdings. Ultimately, $400 billion will be shifted from short-term Treasury securities to long-term Treasury securities.

A rough look at the history of the maturity distribution for the Fed's Treasury holdings shows that long-term securities have traditionally comprised just about 20 percent of the Fed's Treasury holdings. During and after the financial crisis in 2008, that percentage grew closer to 50 percent. The proportion, according to back of the envelope calculations, is expected to balloon. (This is an imperfect measurement, as the availability of detailed data is limited. We have broadly defined short-term securities as those that mature in less than five years, and long-term securities as those that mature in more than five years.)

Figure 3. Federal Reserve Long-Term Treasury Holdings

Another view of this situation looks at the combined holdings of Treasury securities and the agency securities that were purchased as part of previous large-scale accommodative programs. Since the Fed's portfolio mostly includes agency securities with long-term maturities, adding in those types of securities would show that the asset holdings on the Fed's balance sheet will be even more heavily weighted in long-term securities (roughly 78 percent by mid-2012).

Figure 4. Federal Reserve Long-Term Treasury Holdings

What are some of the implications of these changes in the Federal Reserve's balance sheet? Most immediately, the Fed's income from interest payments on purchased securities has risen, from $40.3 billion in 2007 to about $76.2 billion in 2010. Interest income has risen with the share of the balance sheet devoted to long-term bonds because long-term bonds pay more interest than short-term bills. The increase in the Fed's interest income has allowed the Fed to turn more money over to the Treasury each year.

However, in future years, as interest rates rise, the Federal Reserve's income could fall sharply. Specifically, such losses could arise when the Federal Reserve eventually follows through on the FOMC's stated intention to sell some of the long-term assets, to gradually shrink its balance sheet to a more normal size. The reason is that the value of long-term securities falls when interest rates increase, potentially causing the Fed to realize capital losses with the eventual sales of bonds.

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