YELLEN: The case to raise rates has strengthened in recent months
U.S. economic activity continues to expand, led by solid growth in household spending. But business investment remains soft and subdued foreign demand and the appreciation of the dollar since mid-2014 continue to restrain exports. While economic growth has not been rapid, it has been sufficient to generate further improvement in the labor market. Smoothing through the monthly ups and downs, job gains averaged 190,000 per month over the past three months. Although the unemployment rate has remained fairly steady this year, near 5 percent, broader measures of labor utilization have improved. Inflation has continued to run below the FOMC's objective of 2 percent, reflecting in part the transitory effects of earlier declines in energy and import prices.
Prior to the financial crisis, the Federal Reserve's monetary policy toolkit was simple but effective in the circumstances that then prevailed. Our main tool consisted of open market operations to manage the amount of reserve balances available to the banking sector.3These operations, in turn, influenced the interest rate in the federal funds market, where banks experiencing reserve shortfalls could borrow from banks with excess reserves. Before the onset of the crisis, the volume of reserves was generally small--only about $45 billion or so.4 Thus, even small open market operations could have a significant effect on the federal funds rate. Changes in the federal funds rate would then be transmitted to other short-term interest rates, affecting longer-term interest rates and overall financial conditions and hence inflation and economic activity. This simple, light-touch system allowed the Federal Reserve to operate with a relatively small balance sheet--less than $1 trillion before the crisis--the size of which was largely determined by the need to supply enough U.S. currency to meet demand.5
To address the challenges posed by the financial crisis and the subsequent severe recession and slow recovery, the Federal Reserve significantly expanded its monetary policy toolkit. In 2006, the Congress had approved plans to allow the Fed, beginning in 2011, to pay interest on banks' reserve balances.9 In the fall of 2008, the Congress moved up the effective date of this authority to October 2008. That authority was essential. Paying interest on reserve balances enables the Fed to break the strong link between the quantity of reserves and the level of the federal funds rate and, in turn, allows the Federal Reserve to control short-term interest rates when reserves are plentiful. In particular, once economic conditions warrant a higher level for market interest rates, the Federal Reserve could raise the interest rate paid on excess reserves--the IOER rate. A higher IOER rate encourages banks to raise the interest rates they charge, putting upward pressure on market interest rates regardless of the level of reserves in the banking sector.
What does the future hold for the Fed's toolkit? For starters, our ability to use interest on reserves is likely to play a key role for years to come. In part, this reflects the outlook for our balance sheet over the next few years. As the FOMC has noted in its recent statements, at some point after the process of raising the federal funds rate is well under way, we will cease or phase out reinvesting repayments of principal from our securities holdings. Once we stop reinvestment, it should take several years for our asset holdings--and the bank reserves used to finance them--to passively decline to a more normal level. But even after the volume of reserves falls substantially, IOER will still be important as a contingency tool, because we may need to purchase assets during future recessions to supplement conventional interest rate Forecasts now show the federal funds rate settling at about 3 percent in the longer In contrast, the federal funds rate averaged more than 7 percent between 1965 and 2000. Thus, we expect to have less scope for interest rate cuts than we have had historically.
Although fiscal policies and structural reforms can play an important role in strengthening the U.S. economy, my primary message today is that I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.