ECON430-Topic #3: Taper Time

The Federal Reserve has recently been expanding their balance sheet by approximately $85 billion a month in an effort to stimulate the economy through quantitative easing. There are several proposed channels that this would affect the greater economy, mostly related to what Bernanke and Gertler called the credit channel. The credit channel would presumably return the amount of lending to a normal rate or one that is expansionary. The goal of this credit easing is to aid the economy back to health and keep credit markets functioning at or near some desired level. Several studies that have indicated that interest rates are lower as a result of this credit easing, however the effects on the overall economy are unclear.

Currently, the economy is not visibly strong, and banks like Societe Generale and Bank of America have already trimmed their Q3 and Q4 forecasts for U.S. GDP growth due to the effects of the government shutdown and debt ceiling crisis. Furthermore, Senators Rand Paul and Lindsey Graham have threatened to hold up nominations until they get something more on Benghazi (Graham) or Fed transparency (Paul). If the Fed nomination of Janet Yellen is withheld for a long period of time, it might lead to more market uncertainty.

There is some recent news that certain types of loans have increased in number while also becoming more risky. Commercial mortgage backed securities (related to commercial property) have been increasing in number this year, and Moody’s has recently sounded an alarm on this practice due to weak underwriting (i.e., credit checks and due diligence). The current low interest rate environment is expected to continue for some time (the end of 2014?) and the Fed is expected to continue their current policy of purchasing $85 billion of assets every month until at least March 2014.

Questions you might answer:

  • Should the Fed continue their current policy to March 2014 or should they begin tapering sooner? What stories or facts other than the ones mentioned here would indicate a need to adjust their course?
  • What do you expect the Federal Reserve to do if inflation expectations were on the rise? What does the Fed actually target these days anyways? What would it take for the Fed to dramatically change course at this time?
  • If the goal of Fed policy is to operate through the credit channel, what would indicate that this is working? Many economists have worked on this theoretically, but the empirical evidence is pretty weak. See what you can find that would indicate if this policy is working or not. Would a rise in risky CMBS indicate an effective easing policy or something else?
  • What would happen if the nomination of Fed chairwoman Janet Yellen were held up for an extended period. Has this happened in the past with anyone else? Do we have any reason to expect that her nomination will be denied by the Senate?


11 thoughts on “ECON430-Topic #3: Taper Time”

  1. The Fed’s tapering could continue for most of 2014, but the exact date will be unknown/unannounced in order to prevent markets shocks similar to May 22nd when Bernanke issued his warning about possible tapering. The warning was followed by an interest rate hike and the shorting of Treasures via hedge funds. With lackluster economic data (low US job growth and low US GDP growth (Forbes, 2013)) it seems that there will be NO large scale tapering before Bernanke’s 2014 departure from office. In a 100 days from now when Janet Yellen is introduced as Fed chair, it is reasonable to predict that one of her first action will NOT be to enact a large scale taper which would cause market volatility within her first term (not a good first impression). With this being said, it is hard to predict when a large scale taper will happen, but unannounced tapering of $5 billion dollars per purchased could “ease” the tapering. Besides market volatility, the Fed has not begun tapering because it has not met its inflation target. With lower than expected inflation, current and expected growth in prices and GDP have not been strong enough to remove the assistance of the Fed’s purchases.

  2. The Federal Reserve should aim to taper investment spending sooner. The government is in no shape to continue its spending by investing in $85 billion in assets every month given when looking at the budget deficit. However, due to the uncertainty of the market and the threats of delaying Janet Yellen’s acceptance as chairman of the Federal Reserve, it is unlikely that any sudden change of plans will occur. This degree of uncertainty, as a result of the delay into office, most likely will exist regardless if the Federal Reserve remains non-transparent with the public. In addition to the delay of admittance to the Federal Reserve, the psychological effects of the government shutdown also do not necessarily help in regards to consumer confidence in a market. Therefore, it is unlikely that any derivation from the orginal plan will arise. Furthermore, tapering sooner would require complete cooperation between the Senate and the Federal Reserve. This would allow Yellen to take office on schedule and then the Federal Reserve could initiate a plan that would recover the economy and reduce any existing uncertainly in markets.

  3. Although a presidential nomination for the Chairman of the Federal Reserve has never been outright rejected by the Senate, there have been cases in the past where the Senate has executed significant investigations of nominees before ultimately approving them (Business Insider, 2013). In the late 1970s, when Jimmy Carter nominated G. William Miller for the position of Federal Reserve Chairman, the Senate Banking Committee underwent a lengthy process of investigating aspects of Miller’s past in regards to his private corporation’s business proceedings (Romer, 2004). While Miller ended up being largely unpopular, causing him to be ousted as Fed Chairmen after just over a year due to an exceedingly large drop in the value of the dollar and rampant inflation under his tenure, it cannot be said with certainty that a delay in Yellen’s approval by the Senate will have adverse economic implications (Economic Policy Journal, 2012). Comparing the two situations is irrational based on the vastly different backgrounds of Miller (little to no monetary experience) and Yellen (tenure at the San Francisco Fed). So, while the uncertainty of whether Yellen’s approval occurs in a timely fashion or not may have negative economic effects, past examples of this cannot be said to dictate that this will definitely occur. In regards to whether or not a potential hold placed on Yellen’s nomination will lead to a rejection, the odds of that are unlikely. It has never happened before and Yellen only needs 60 Senate votes to circumvent any threatened hold.

  4. The possibility of an extended period of delay for the nomination of Janet Yellen as Fed chair would fuel to fire of uncertainty that is already plaguing the American economy and banking system. Since the other Federal Reserve chair candidates have such different monetary policies and beliefs it would further delay the process of turning policy into law. Republican Senator Rand Paul of Kentucky and Sen. Lindsey Graham from South Carolina are determined to delay their nominations until they get further information on specific topics. Paul is concerned about getting a vote for his “Fed transparency” bill while Graham is demanding more information on homeland security, in particular the Benghazi matter. The transparency bill is designed to audit the fed and would eliminate restrictions. Paul believes the fed is structurally flawed and wants to fix the system by reducing the power of the Fed before Yellen takes the throne. “Yellen has been not merely an engineer of the Fed’s policies of ‘quantitative easing’ and ‘forward guidance,’ but a consistent voice within the central bank to go further” (Blades 2013).
    Grahams is using the holdout of the nomination as the only leverage left in the political battle over Benghazi, when al Qaeda associates attacked U.S outposts on September 11, 2012. Republicans believe there are many unanswered questions to this case and believe a democratic cover up may have taken place in order to ensure Obama’s 2012 re-election. Graham wants people to be held accountable for the actions.
    Yellen is well aware of these potential threats and has planned meeting with various senators to explain her side of the story. In order to get rid of the hold, Harry Reid, the Senate majority leader, needs to get the support of 60 of the senators. The believed democratic control on the nomination is 54-46 which means another 6 senators needs to be convinced to change.

  5. If the federal reserve found out that people were expecting high inflation they would most likely stay with policies that would convince people, public, and private sectors. Although most don’t believe that we are in a liquidity trap, i believe that we are and that the only way to get out of it is to change expectations and keep those areas convinced that, that change will happen otherwise the expectations will revert back and the government will still be stuck in a liquidity trap. I think that their will be continued economic easing also in this situation since it does help convince the sectors of inflation. Along with this the fed will continue doing this until they reach their target rate that pushes good economic systems throughout the economy. If the fed did want to dramatically change course all they would have to do is change polices again. They would want stop doing monetary easing and re-target lower interest rates. A dramatic change back towards a situation we are trying to escape is much easier to do by just reverting to previous policies.

  6. President Obama recently announced his nomination of Janet Yellen as successor to Ben Bernanke as Federal Reserve president. As of late, Rand Paul has expressed his intention to impede her nomination in the hopes of increasing the level of transparency in the central bank. Currently Bernanke is acting as president of both the Federal Reserve and the FOMC, Janet Yellen and William Dudley are the vice presidents respectively. As vice president, in the exit of Bernanke from his chair, she is next in line to head the bank. Rand Paul’s attempt to halt her official appointment would have no real implications on the real economy. Mrs. Yellen would still be the spearhead behind any decisions that the bank would continue to make as acting Fed chairman. The real implications of Mr. Paul actions will be seen in the faith entrusted into the central bank. By blocking her nomination, Paul essentially is creating more instability and uncertainty concerning the Fed. This furthers the notion that American politics continues to strongly influence behavior of the Federal Reserve. Such actions make it harder for the bank to effectively conduct monetary policy and control interest rates if the public is unclear as to when the new president will be inducted.

  7. Possible signals of effective monetary policy through the credit channel include credit growth, final demand for goods and services, and added employment from increased demand for goods and services, as argued by Dennis Lockhart. In relation to credit growth, Lockhart mentioned broad-based loan growth across various sectors, including industrial loans, auto loans, credit card receivables, and mortgage loans, as well as securitization for these loans. Ben Bernanke focused on negative effects of monetary tightening in his initial discussion of the credit channel in 1995, arguing that rising interest rates ultimately impair banks’ capital and reduce their capacity to make loans. In 2007, Bernanke also noted that historically, monetary tightening resulted in a decline in the extension of credit to firms and households. From Bernanke’s arguments, we can infer that monetary easing could be expected to result in credit growth.

    If these are measures are reliable indicators of effective monetary policy, it is possible that near record levels of leverage loan issuance and increases in risky CMBS issuance signal effective easing policy. However, credit growth is only one factor. If the credit growth is not translated into increased demand for goods and services and higher employment from said demand, the easing would be ineffective (assuming employment is the Fed’s focus). In such a case, a rise in risky loan and securitization issuance could be a sign of a reach for yield by investors, as noted by Jeremy Stein.


  8. If the Federal Reserve is operating through the credit channel, an increase in bank lending leading to real effects on the economy would represent effective policy. In a Fed survey released earlier this afternoon, Nov. 4, 2013, Fed officials stated that residential lending is close to all time highs while commercial and industrial lending is almost nonexistent (MNI News). This can be seen as a good sign because as households increase their borrowing and spending, businesses are the ultimate beneficiaries and can begin borrowing and spending as well. The little bit of commercial lending that is occurring is then being securitized and sold as CMBS. The fact that there has been an increase in underwriting of CMBS in recent months is not surprising. CMBS and other types of mortgage-backed securities provide exposure to an asset type that is relatively unavailable otherwise. Additionally, these securities offer higher yields than other investments with similar credit ratings. For example, the 5 year treasury note currently yields about 1.36% ( The safest tranche of a CMBS deal issued in January yields about 1.90%. These two investments hold high credit ratings. Investors can also take on more risk to earn higher yields. The double A rated tranche yielded about 2.5% (reuters). The fact that underwriting standards have declined is a bit alarming. The most recent financial crisis was fueled largely in part to loose lending and underwriting standards (Forbes). While the top tranches of these deals offer good investment opportunities, the lower, subprime tranches can be very risky. These, however, are the most appealing as they offer high yields. One can only hope that market participants learned their lesson from the most recent financial crisis.

  9. Monetary easing should yield certain responses of GDP and its components that the credit channel can explain:
    1) Sustained inclines in real GDP and the Price Level
    2) After an initial shock, final demand will rise quickly with production following upwards with a lag. This implies inventory stocks fall in the short run but eventually rise. This investment should account for a large portion of the decline in GDP.
    3) The earliest and sharpest inclines in final demand should occur in residential investment, with spending on consumer goods close behind
    4) Fixed business investment eventually inclines in response to easing but it increase lags behind those of housing and consumer durables and much of the incline in production and interest rates.
    (Bernanke and Gertler 1995)
    Bernanke states that the reason why short-term changes in interest rate result in long-term effects is the result of the inverse relationship between the external finance premium and the financial condition of the borrower. The external finance premium is the cost of raising outside funds minus the opportunity cost of using internal funds. The balance sheet mechanism is related to the financial accelerator and the logic follows that if you change interest rates, you change the price of assets, and alter the cash flows of borrowers, which in turn affects their credit worthiness, that ultimately affects their external finance premium. Comparing the changes of the effective cost of credit relative to the risk free rates would tell us if operating through the credit channel is working because we would want to see a reduction in the external finance premium. The bank lending channel story implies that changing monetary policy affects the banks loanable funds which affects the total amount of intermediate credit. But this may not be very applicable in the United States since the capital markets have become deep, liquid, and easily accessible to almost all depository institutions. With nonbank financing, creditworthiness of the bank is now important; financial condition is now important. (Bernanke) The Bloomberg U.S. Financial Conditions Index (BFCIUS) has reached the highest point since 1994. The increase of financial conditions would allow one to argue that this is a result of the fed’s targeting of the credit channel is effective. (Bloomberg)

    Bernanke and Gertler 1995: Inside the Black Box: The Credit Channel of Monetary Policy Transmission. Ben S. Bernanke, Mark Gertler. NBER Working Paper No. 5146. Issued in June 1995.
    Bernake: Ben S. Bernanke. Speech. At the The Credit Channel of Monetary Policy in the Twenty-first Century Conference, Federal Reserve Bank of Atlanta, Atlanta Georgia. June 15, 2007

  10. Recently, the Fed has relied on nontraditional monetary expansionary policies to stimulate the economy. It has already pumped trillions of dollars into the economy through quantitative easing. It is interesting to me to compare how the Fed’s monetary policy relates to both the mission and role of the Fed. By purchasing mortgage-backed securities, it is essentially changing the composition of the riskiness of assets in the market. Second, it stated that QE3 would be in place until economic conditions improved. For the first time, the Fed enacted quantitative easing indefinitely. Lastly, the Fed targeted the labor market. It stated that it will continue to purchase mortgage-backed securities and other assets until the labor market substantially improves.The Fed has been criticized for not only the changes it has made regarding its role, but also the way in which it went about changing its role. Many criticize the Fed, arguing that the policies the Fed enacted were unprecedented. For example, Senator Paul and his father are seeking more transparency within the Fed. In some ways, increasing transparency would limit the real affects of their actions on the economy because systematically fooling US citizens allows for real changes within the economy.

  11. The typical story told by economists is that the Fed will reduce the money supply if it believes that inflation expectations are on the rise. In reality the Fed targets interest rates by manipulating the interest rate available to banks for inter-bank lending. Given that the current economic conditions indicate that the United States is still in a liquidity trap, both Eggertsson and Svensson would suggest the Fed commit to allowing the higher rates of inflation. However, the Fed has instead repeatedly stated that it has a commitment to keeping a two percent inflation rate. In order to achieve this goal it will likely need to increase the interest rate paid on reserves held at the Fed. This will encourage banks to continue holding more excess reserves, so as the monetary base continues to grow the money supply will not dramatically increase.

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