A new study concludes that under Ben Bernanke, the Federal Reserve’s extraordinary measures to fight the financial crisis cut the unemployment rate by about 1 percentage point from what it would otherwise have been. That’s not a huge success given all the bullets fired by the Bernanke’s Fed, including purchases of assets that ballooned the central bank’s balance sheet to more than $4 trillion.
The study (pdf) by economists at the University of Chicago Booth School of Business and the University of California at San Diego compares the unemployment rate in December 2013 with what the rate would have been if the Fed had never let the federal funds rate go below 0.25 percent and never bought assets or signaled its intentions to keep rates low for a long time (“forward guidance”). The actual jobless rate in December was 6.7 percent, so the implication is that it would have been around 7.7 percent.
The researchers—Jing Cynthia Wu of Chicago and Fan Dora Xia of San Diego—also compared the Fed’s results with what would have happened if the central bank had followed a so-called Taylor rule, named after Hoover Institution economist John Taylor. That rule prescribes what interest rates should be, given various levels of inflation and unemployment. Unemployment in December was 0.13 percentage point lower than if the Fed had followed the Taylor rule, which would have prescribed less extreme actions than the Fed actually pursued, Wu and Xia conclude.
James Hamilton of the University of California at San Diego, an economist and author of the Econbrowser blog, advised Wu when she was a Ph.D. candidate at San Diego as well as Xia, who completed her doctorate this year. “I think this is really interesting research,” he said in an interview. As for the estimates of the impact of Fed actions, Hamilton added: “I think those are smaller numbers than the Fed thinks they accomplished.”
For economists, the most interesting aspect of the paper may not be the impact estimates but the method that Wu and Xia invented to arrive at those estimates. They came up with an easy-to-use approximation of an elegant solution proposed in 1995 by Fischer Black, when he was dying of cancer, in a paper titled “Interest rates as options.” Black’s name is on the Black-Scholes option-pricing model, and he would have won a Nobel Prize along with co-inventors Myron Scholes and Robert Merton in 1997 if he had been alive.
The problem faced by Black as well as by Wu and Xia is what to do when short-term interest rates hit what’s known as the zero lower bound and can’t drop any further. When the economy is extremely weak, the Fed would like to reduce rates below zero—paying people to borrow money and charging them to keep it on deposit. Rates can’t actually go much below zero, of course. But the Fed can use other tools, such as quantitative easing, to make financial conditions as easy as if the federal funds rate were negative.
Working from Black’s concept, Wu and Xia found a way to calculate a “shadow” federal funds rate—in effect, the rate at which the Fed would have set fed funds if it could have set rates negative. The general idea is to look at longer-term rates that are still positive and extrapolate from them down to hypothetical short-term rates, taking into account the level, slope, and curvature of the yield curve. According to Wu and Xia, the shadow federal funds rate at the end of 2013 would have been around negative 2 percent.