[size=1.3em]Risks and uncertainty

Although the evidence shows that the Fed’s unconventional policy actions have been effective at lowering interest rates and stimulating economic growth, it’s also clear that there remains a great deal of uncertainty about the effects of these policies. After decades of using the fed funds rate as the main tool of monetary policy, Fed policymakers have plenty of confidence in this instrument. We know it works and we’re pretty good at estimating how much it works. By contrast, with unconventional monetary policies, we’re in waters that have not been extensively charted. We don’t know all the consequences. There is uncertainty about the magnitude of the effects on the economy, as I’ve already discussed. In addition, there is a concern that these policies carry with them risks of unintended negative consequences. Let me go over a few of those concerns.

One concern is that the Fed’s very low rate policies may be building up inflationary pressures that we can’t yet see (see Williams 2012a). Of course, this risk is not peculiar to unconventional policies. It exists whenever monetary policy is very expansionary. Although this is a risk, it’s important to note in the current context that inflation has been very low during this period of unconventional policies, and it remains so. Moreover, the public’s inflation expectations remain well anchored. So, we are not seeing signs of rising inflation on the horizon. Japan’s experience with unconventional policies is informative as well. Japan has had undesirably low inflation since the 1990s despite the Bank of Japan’s very large quantitative easing programs.

Nonetheless, whenever a stimulatory monetary policy is in place, there is always a risk of inflation rising too high. Let me emphasize that the Fed has the tools to combat such a threat if it were to materialize. We can raise interest rates, slowing economic growth. And we can reverse the asset purchase programs, selling assets back into the market if needed.

A second concern is that these policies may be contributing to excessive risk-taking in financial markets as investors seek higher yields in the low-rate environment. I take this concern seriously. We monitor indicators of financial market conditions very closely, looking for signs of imbalances or excesses. In addition, in our role as bank supervisors, we carefully watch for signs of inappropriate risk-taking. We are always on the lookout for indications that the low-rate environment is creating dangers for the banking system. That said, as of today, most indications still point to an environment of heightened risk aversion rather than reckless risk-taking in our financial system. Memories of 2008 are simply too close for most financial market participants to go out on a limb. If that situation were to change significantly, we could modify our unconventional policies to mitigate undesired effects on risk-taking.

I’ve highlighted the uncertain effects of unconventional policies and some concerns about undesired consequences of these policies. But, the presence of uncertainty does not mean that we shouldn’t be using these tools. That is the point that William Brainard analyzed 45 years ago in his classic paper on optimal policy under uncertainty. The answer Brainard (1967) found was that a policy tool with uncertain effects should not be discarded. However, it should be employed more cautiously than policy tools that have more certain effects. This insight applies to the current situation. The Fed has been deliberate in using its unconventional policies over the past few years. We’ve carefully weighed the benefits of these policies on improving economic growth against potential risks and uncertainties.

[size=1.3em]Conclusion

Let me offer some final thoughts. Unconventional monetary policies such as forward guidance and large-scale asset purchases give central banks effective instruments when the traditional policy interest rate is near zero. The Fed and other central banks have been actively using these policies. In the United States, these policies have had meaningful effects on longer-term interest rates and other financial conditions. The precise impact on unemployment, GDP, and inflation is harder to determine. But the available evidence suggests they have been effective in stimulating growth without creating an undesirable rise in inflation. Conducting monetary policy always involves striking the right balance between the benefits and risks of a policy action. As the FOMC statement makes clear: “In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.”

John C. Williams is president and chief executive officer of the Federal Reserve Bank of San Francisco.