Fed's Yellen: Another Downturn Could Call for Asset Purchases

--Lower Neutral Rate Means Less Scope to Cut Rates in Next Downturn

--Will Likely Need to Restart Asset Purchases Again When Rates Near Zero

--Term Premia to Rise Only Gradually as Assets Roll Off

By Jean Yung

     WASHINGTON (MNI) - Federal Reserve Chair Janet Yellen warned Friday that it

wouldn't take another downturn on the scale of the Great Recession to drive

short-term interest rates back to zero, at which time the central bank will

likely need to redeploy unconventional policy tools such as asset purchases and

forward guidance. 

     With the estimated neutral rate of the federal funds rate at a historically

low level, "there will typically be less scope for the FOMC to reduce short-term

interest rates in response to an economic downturn, raising the possibility that

we may need to resort again to enhanced forward rate guidance and asset

purchases to provide needed accommodation," Yellen said in remarks prepared for

the National Economists Club in Washington. 

     "If we are indeed living in a low-neutral-rate world, a significantly less

severe economic downturn than the Great Recession might be sufficient to drive

short-term interest rates back to their effective lower bound," she said. 

     The Federal Open Market Committee last month revised lower its estimate of

the neutral rate to around 2.75%, compared to 4.25% just a few years ago. With

rates currently in the target range of 1.00% to 1.25%, there is not much room to

raise rates before monetary policy becomes contractionary. 

     Though the fed funds rate remains the Fed's primary policy tool, odds are

"uncomfortably high" that when rates have been slashed back to zero in the

future, the Fed would have to reach again for balance sheet tools. 

     Studies show that the Fed's large-scale asset purchases in the wake of the

financial crisis helped lower longer-term interests when rates were already at

the zero lower bound, Yellen noted. 

     As the economy recovered, the Fed began to scale back policy accommodation,

first by raising rates and then by allowing some reinvestments of maturing

assets to end starting this month. 

     With the process now under way, it is likely that the Fed's asset holdings

are "now depressing the term premium on the 10-year yield by somewhat less than

the 1 percentage point estimate reported for late last year," Yellen said. That

downward pressure will likely "diminish only gradually" through the roll-off

process and the Fed does not anticipate a jump in term premiums, she added. 

     It will take "some years" for the Fed's balance sheet to normalize via

runoff, she said. 

     Meanwhile, "we must recognize that our unconventional tools might have to

be used again" to provide additional policy accommodation after short-term

interest rates reached their effective lower bound, the chair said. 

     And upon sufficient recovery of labor markets and inflation, the Fed will

again need to scale back that accommodation, she said. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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