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Economic Brief

December 2012, EB12-12

A Citizen’s Guide to Unconventional Monetary Policy
By Renee Haltom and Alexander L. Wolman

Historically, the Federal Reserve’s primary monetary policy tool has been
the federal funds rate. Since pushing that rate as low as it can effectively go
in December 2008, the Fed has turned to alternative policy tools to stimulate
economic growth and keep inflation near 2 percent. This Economic Brief
provides a non-technical guide to how these unconventional policy tools
are intended to work and discusses some of their risks.
Prior to 2008, the gist of the Federal Reserve’s
monetary policy could be conveyed with one
sentence: Lower short-term interest rates to
stimulate growth when the economy is weak,
and raise them to prevent inflation when the
economy is strong. Monetary policy became
much more complicated in December 2008,
when the Fed pushed its main policy rate,
the target federal funds rate, as low as it can
effectively go.1 This unusual situation is called
the “zero lower bound” (ZLB) on nominal interest rates.2 Once the Fed confronted the ZLB, it
turned to alternative tools to ease monetary
policy further. These unconventional monetary policy tools fall into three general areas:
increasing the size of the Fed’s balance sheet;
altering the composition of its balance sheet;
and providing increasingly detailed guidance
about the likely future path of policy.3
Before discussing the new tools further, it is
important to note that the Fed’s objectives
have not changed. The Fed is bound by the
congressionally established mandate to promote both maximum sustainable employment
and price stability, together referred to as the
“dual mandate.”

EB12-12 - The Federal Reserve Bank of Richmond

Expanding the Balance Sheet
In normal times—that is, when the Fed is not
facing the ZLB on nominal interest rates—the
Fed loosens monetary policy by reducing the
federal funds target rate and the primary credit
rate (better known as the discount rate). These
actions tend to translate into lower interest rates
elsewhere in the economy. The announcement
of a lower target rate is accompanied by a commitment to perform whatever open market asset
purchases might be necessary to ensure that
the actual federal funds rate falls along with the
target rate. Asset purchases expand the Fed’s
balance sheet and inject funds into the banking
system. Though today the ZLB means the central
bank cannot push its policy interest rate lower,
the Fed still can purchase assets in an attempt to
influence broader market interest rates. Accordingly, the first unconventional monetary policy
move of the past several years has been to make
large-scale asset purchases (LSAPs), often called
“quantitative easing” (QE).4 This has occurred in
three rounds:
From November 2008 through March 2010,
the Fed purchased $1.75 trillion in long-term
Treasuries as well as debt issued by Fannie

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Mae and Freddie Mac and fixed-rate mortgagebacked securities (MBS) guaranteed by those
agencies. (This first round has been called QE1.)
From November 2010 through June 2011, the Fed
purchased $600 billion in long-term Treasuries
And in September 2012, the Fed announced that
it would purchase $40 billion in agency-backed
MBS per month until economic conditions improved substantially (QE3).
These LSAPs have expanded the Fed’s balance sheet
significantly. (See Figure 1.) As noted, the purpose of
LSAPs is to put downward pressure on overall market
interest rates. LSAPs can lower market interest rates
through two channels.5 The first is the portfolio rebalance channel. Many investors are not indifferent
between holding different types of long-term assets.
For example, they may be restricted by regulations
from holding certain assets, or they may have preferences for assets with certain risk characteristics.
Because assets are not perfectly substitutable, and
LSAPs change the relative supply of assets available
to investors to purchase, LSAPs have the potential to
change asset prices and interest rates. The second
way LSAPs could lower market interest rates is by

signaling that the Fed is likely to keep its policy rate
low for a longer period than previously believed.
The Fed’s willingness to engage in LSAPs could have
this signaling effect if they provide new information
about the economic forecast or about how stimulative the Fed is willing to be. Additionally, exiting from
the LSAP policy quickly would require significant
asset sales that could disrupt markets. In contrast, a
slow exit would be accomplished by simply waiting
for the assets to mature and roll off the Fed’s balance
sheet. Therefore, if market participants expect the
Fed to begin reducing the size of its balance sheet
before raising rates, then larger LSAPs could signal
that rates are likely to stay low for a longer time.
In fact, one danger posed by LSAPs is that they may
exacerbate the risk associated with the Fed “getting behind the curve” in raising interest rates as
the economy strengthens. LSAPs have significantly
increased the amount of excess reserves in the
banking system. In the five years prior to late 2008,
excess reserves ranged between 1 percent and
20 percent of total reserves; today, 94 percent of
reserves are excess reserves. Large excess reserves
can lead to inflation if banks use those reserves to
fund lending, thereby increasing the money supply.
This has not occurred thus far, and the Fed has tools
to prevent it. In particular, the Fed could raise the

Figure 1: Federal Reserve Assets

First Round
of LSAPs Begins

Billions of Dollars


Second Round
of LSAPs Begins

Third Round
of LSAPs Begins



Treasury Securities

Agency Debt




Mortgage-Backed Securities


Note: Rapid growth of the “other” category prior to the first round of LSAPs was due to Fed actions to provide liquidity
during the financial crisis, such as liquidity swaps with other central banks and loans to certain institutions and markets.
Source: Federal Reserve Board of Governors H.4.1 Release

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interest rate it pays banks to hold reserves, which
would discourage lending by reducing the opportunity cost of holding reserves. While the Fed
always can raise interest rates, there is no guarantee that it will know when the appropriate time has
come to do so. The presence of a large quantity
of excess reserves may heighten the economy’s
sensitivity to policy mistakes because the reserves
represent a ready source of funding for banks to
expand their activities.6
Altering the Composition of the Balance Sheet
When the Fed purchases assets, whether through
traditional monetary policy or through LSAPs, it
must choose which assets to buy. Traditionally, the
Fed has purchased primarily short-term Treasuries
because they are highly liquid and safe.7 In addition,
purchasing Treasuries is a relatively neutral way to
affect the financial system because Treasury purchases affect a broad array of other market interest
rates, and therefore do not favor certain sectors over
others. In the past several years, the Fed has deviated from this behavior in two key ways:
The Fed purchased large quantities of agencybacked MBS in the amounts described above.
The Fed replaced $667 billion in short-term
Treasuries on its balance sheet with an equivalent amount in longer-term Treasures between
September 2011 and the end of 2012. This
action is the “maturity extension program” (MEP),
but is often called “operation twist” for its intent
to “twist” the yield curve.8
The direct result of these actions has been to alter
the composition of the Fed’s balance sheet.9 Today
less than 60 percent of the Fed’s assets are Treasuries, compared to more than 90 percent prior to the
financial crisis. In addition, the Fed has altered the
average maturity of the Treasuries it holds. The Fed’s
purchases of MBS are intended to provide support to
mortgage markets by lowering related interest rates.
Through the MEP, the Fed intends to put downward
pressure on interest rates on assets that are close
substitutes for longer-term Treasuries in order to
ease broader lending conditions and support the
economic recovery.

One risk concerning these targeted balance sheet
policies is that they may disrupt the efficient allocation of credit. If the Fed’s acquisition of MBS is successful in raising their prices, then purchasing MBS
would reduce interest rates on mortgage loans. This
directs credit to borrowers in mortgage markets.
Directing credit to mortgage markets may increase
lending costs in other markets, favoring some borrowers over others. Some FOMC members, including
Richmond Fed President Jeffrey Lacker and Philadelphia Fed President Charles Plosser, have argued that
this would be a more appropriate role for fiscal policy,
which is subject to political checks and balances.10
Furthermore, after proving its willingness to conduct
credit allocation, a central bank could experience
political pressures to allocate credit in a specific way.
There are additional political risks associated with the
Fed holding a large balance sheet composed of more
risky assets. Reversing the monetary easing provided
by LSAPs will involve some combination of selling
those assets and raising the interest rate on excess reserves. Both of these actions will reduce the amount
of money the Fed turns over to the Treasury at the
end of each fiscal year.11 An extreme but still possible
outcome would involve the Fed’s income falling so
much that it would need to seek appropriations from
Congress to cover its operating expenses. Such a scenario could jeopardize the Fed’s operational independence from Congress.
Increasing Forward Guidance
Compared to its unprecedented balance sheet
policies, the Fed’s new practice of providing more
information about future monetary policy might
sound much less consequential, but greater “forward
guidance” (FG) could have a significant effect on the
economy. Forward guidance refers to statements
the FOMC includes in its post-meeting press releases
about what the committee is likely to do or not do
in the future. FOMC statements have included FG
since 1999, but the statements became much more
detailed during the recent financial crisis:
From March 2009 through June 2011, the statements indicated that economic conditions “are
likely to warrant exceptionally low levels of the
federal funds rate for an extended period.”
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From August 2011 through December 2011, the
statements provided an anticipated calendar date
of future policy changes by stating that conditions “are likely to warrant exceptionally low levels
for the federal funds rate at least through mid2013.” The calendar date was extended to late
2014, starting in 2012, and extended to mid-2015
in September 2012.

New York Fed and Columbia University, respectively,
show in a 2003 paper that at the ZLB, it is optimal
for the central bank to raise inflation expectations,
which it can accomplish by credibly committing to
making monetary policy “too easy” in the future.15
This commitment lowers real interest rates (nominal
rates adjusted for inflation), which makes spending
today more attractive relative to spending tomorrow.16

In its September 2012 and October 2012 statements, the FOMC stated that rates are likely to
stay low “for a considerable time after the economic recovery strengthens.”

While the calendar date might give markets a concrete forecast for short-term interest rates given
current economic data, it leaves room for interpretation over what policy rule the central bank is following in choosing that date. Therefore, it does not help
financial market participants understand how policy
might change if economic conditions change, nor
how policy is likely to behave after the calendar date.

FG is intended to help markets form accurate expectations about the likely course of monetary policy. In
fact, because markets are good at anticipating the
Fed’s policy changes, FG often moves markets more
than actual changes in the federal funds rate.12
FG might be an especially useful monetary policy
tool at the ZLB precisely because it does not rely on
the ability to change current policy rates. Federal
Reserve Chairman Ben Bernanke has explained that
the Fed’s use of FG since March 2009—four months
after hitting the ZLB—has been intended to lower
expected short-term rates, therefore lowering longterm rates, which are a function of expected shortterm rates. That would stimulate economic activity
by lowering interest rates on a variety of loan types.13
The most obvious risk associated with FG, as with any
form of communication, is that the Fed’s statements
could be misunderstood. Many observers (including
several FOMC members) have argued that this risk
exists when the FOMC communicates about future
policy in terms of a calendar date. The calendar date
could refer to the date when the FOMC thinks its
policy rule will warrant a policy change given the
economic forecast. Alternatively, the date could refer
to a point after which its policy rule and the forecast
suggest policy should change, such that the Fed is
conveying that it will keep policy easier than future
conditions warrant.14 The latter is a strategy that
theoretical studies have shown might be useful for
economies that have stagnated at the ZLB. For example, Gauti Eggertsson and Michael Woodford, at the

In the Eggertsson and Woodford model, the commitment to making monetary policy “too easy”
would only stimulate economic activity if the commitment is viewed by the public as highly credible.
That is, markets must believe that the central bank
will, in fact, hold rates “too low” in the future simply
because it promised to in the past, despite the fact
that at that point, it would wish to raise rates to avoid
inflation. Using a calendar date in FG rather than
directly stating that it is following the “too easy”
strategy could signal that there is internal disagreement at the central bank over whether the “too easy”
strategy is desirable. If policymakers agree on the
policy, it would leave less room for interpretation to
state the policy rule directly and allow private agents
to form expectations about calendar dates based on
incoming data. If, instead, there is no internal agreement about the strategy of committing to “too easy”
policy, the calendar date may be the only thing on
which it is possible for policymakers to agree, based
on their respective policy rules.17
In September and October of 2012, the FOMC statement said that rates are not likely to rise until “a considerable time after the economic recovery strengthens” (italics added). This language looks more like the
type of overt commitment to “too easy” policy suggested by Eggertsson and Woodford, and thus might
imply to markets that the Fed is willing to tolerate

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above-target inflation. Raising inflation expectations
is, in their model, the point of the policy, but in reality there is a risk that longer-term inflation expectations might become unanchored. Mitigating that risk
requires convincing the public that any deviation of
inflation from its target will be strictly temporary—a
one-time byproduct of the Fed’s efforts to jolt the
economy out of economic weakness at the ZLB. Conveying this credibly and without misinterpretation
could be difficult.
A final and quite different risk is that FG could contribute to a steady state in which inflation is too low.
In the long run, nominal interest rates and inflation
move together. This is the “Fisher effect,” named
after the late American economist Irving Fisher. If a
central bank commits to low interest rates for a very
long period of time, it is possible that expectations
would settle on a long-run deflationary equilibrium. This possibility was raised in a 2010 speech by
Minneapolis Fed President Narayana Kocherlakota,
although he emphasized that he thought it highly
unlikely to unfold in practice.18 We do not have
experience with long periods of forward guidance.
However, Japan’s experience of essentially zero
nominal rates and intermittent deflation—a situation
that has persisted for more than a decade—provides
good reason to consider all the possible implications
of extended forward guidance.
FG is likely to be a permanent addition to central
bankers’ toolkits because of the value of accurate
private sector forecasts. The way FG has been used in
the past five years—tying future policy to the severity of present conditions with an uncertain degree
of commitment to following through—is inherently
tricky. It poses both upside and downside risks to
inflation, revealing how little certainty there is about
the use of FG at the ZLB, and thus why it should be
approached carefully.
Similar cautions could be extended to the other unconventional monetary policy tools employed by the
Fed and other central banks in the past several years.
Historically, facing the ZLB has been an extremely
rare event, and as a result, many of these policies
have been tested only in theory. It is too soon for

textbooks to be rewritten with the full scope of the
effectiveness and risks of unconventional monetary
policy at the ZLB, but the recent experience will undoubtedly provide useful insight.
Renee Haltom is a writer and Alexander L. Wolman
is an economist and vice president in the Research
Department of the Federal Reserve Bank of Richmond.

In December 2008, a range was established for the target
federal funds rate of 0 to 0.25 percent.


For an overview of why zero might be the lower bound on
interest rates, see Todd Keister, “Why Is There a Zero Lower
Bound on Interest Rates?” Federal Reserve Bank of New York
Liberty Street Blog, November 16, 2011.


The unconventional monetary policy tools described in this
Economic Brief are not the Fed’s only new policy tools. The
Fed also has engaged in lending to a variety of markets and
institutions during the worst days of the financial crisis.
These moves were done primarily to provide liquidity to
those markets, rather than to provide monetary easing, and
so are not discussed here. Additionally, in October 2008, the
Fed started paying banks interest on their excess reserves.
Because interest on reserves was not adopted to provide
monetary easing, it also is not discussed here.


Referring to LSAPs as “quantitative easing” is a bit of a misnomer because the word “quantitative” focuses undue
attention on increasing reserve balances in the banking
system. LSAPs, in contrast, are intended to lower market
interest rates.


The two channels are discussed in detail in a previous
Economic Brief. See Renee Haltom and Juan Carlos Hatchondo,
“How Might the Fed’s Large-Scale Asset Purchases Lower
Long-Term Interest Rates?” Federal Reserve Bank of Richmond
Economic Brief, no. 11-01, January 2011.


For an extended discussion of this risk, see Huberto M. Ennis
and Alexander L. Wolman, “Excess Reserves and the New
Challenges for Monetary Policy,” Federal Reserve Bank of
Richmond Economic Brief, no. 10-03, March 2010; and, by
the same authors, “Large Excess Reserves in the U.S.: A View
from the Cross-Section of Banks,” Federal Reserve Bank of
Richmond Working Paper No. 12-05, August 2012.


The Federal Reserve Act prevents the Fed from purchasing
many types of private assets.


Operation twist was the name of a 1961 program with a
similar objective.


Due to the liquidity policy described in footnote three, the
composition of the Fed’s balance sheet first began to change
in the second half of 2007, which was prior to the LSAPs
and MEP.


See Jeffrey Lacker, “Perspectives on Monetary and Credit
Policy,” Speech to the Shadow Open Market Committee

Page 5


Symposium, New York, N.Y., November 20, 2012; and Charles
I. Plosser, “Fiscal Policy and Monetary Policy: Restoring the
Boundaries,” Speech to the U.S. Monetary Policy Forum at the
University of Chicago Booth School of Business, New York,
N.Y., February 24, 2012.

This article may be photocopied or reprinted in its
entirety. Please credit the authors, source, and the
Federal Reserve Bank of Richmond and include the
italicized statement below.

The discussion here primarily concerns the Fed’s balance
sheet, as opposed to the consolidated U.S. government
balance sheet. The implications of selling assets in a falling
market for the consolidated balance sheet differ somewhat
depending on whether the assets are government liabilities
(i.e. Treasuries) or government-guaranteed MBS.

Views expressed in this article are those of the authors
and not necessarily those of the Federal Reserve Bank
of Richmond or the Federal Reserve System.


See, for example, the evidence presented by Refet Gurkaynak,
Brian Sack, and Eric Swanson in “Do Actions Speak Louder
than Words? The Response of Asset Prices to Monetary Policy
Actions and Statements,” International Journal of Central
Banking, vol. 1, no. 1, 2005, pp. 55–93.


Ben S. Bernanke, “Monetary Policy since the Onset of the
Crisis,” Speech at the Federal Reserve Bank of Kansas City
Economic Symposium, Jackson Hole, Wyo., August 31, 2012.


The question of which message markets have received is
investigated by Charles L. Evans, Jeffrey R. Campbell, Jonas
D.M. Fisher, and Alejandro Justiniano in “Macroeconomic
Effects of FOMC Forward Guidance,” Brookings Institution,
Spring Panel on Economic Activity, paper, March 22, 2012.


See Gauti Eggertsson and Michael Woodford, “The Zero
Bound on Interest Rates and Optimal Monetary Policy,”
Brookings Papers on Economic Activity, Spring 2003,
pp. 139–211.


For related work, see Iván Werning, “Managing a Liquidity
Trap: Monetary and Fiscal Policy,” National Bureau of Economic
Research Working Paper No. 17344, August 2011.


In the past year, lack of unanimity has been more than perception. Richmond Fed President Jeffrey Lacker has dissented
over the use of calendar dates each time they have been
used in 2012, in addition to dissenting on other aspects
of policy.


See Narayana Kocherlakota, “Inside the FOMC,” Speech in
Marquette, Mich., August 17, 2010.

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