Money and Banking Chapter 18

Introduction

-Between September 2007 and December 2008, the FOMC lowered its target for the federal funds rate 10 times. -This was the first time since the 1930s that the nominal federal funds rate hit zero. -Zero lower bound: The idea that nominal interest rate cannot fall below zero. (Due to transaction costs, they can fall below zero). -Effective lower bound: The nominal interest rate level below which intermediaries and their customers will switch from bank deposits to holding cash.

Discount Lending, the Lender of Last Resort, and Crisis Management

-By controlling the quantity of loans it makes, a central bank can control the size of reserves, the size of the monetary base and interest rates. -Today, lending by the Federal Reserve Banks to commercial banks, called discount lending, is usually small aside from crisis periods. -Discount lending is the Fed's primary tool for ensuring short-term financial stability, eliminating bank panics, and preventing the sudden collapse of institutions that are experiencing financial difficulties. -The central bank is the lender of last resort that makes loans to banks when no one else will or can.

The Target Federal Fund Rate and the Interest on Excess Reserves

-Discrepancies between actual and desired reserves gave rise to a market for reserves. -Some banks can lend out excess reserves. -Some banks will borrow to cover a shortfall. -Without this market, banks would need to hold substantial quantities of excess reserves as insurance against shortfalls. -These loans are unsecured. -Banks demand fewer reserves as the market federal funds rate rises. -The Fed continues to be the monopoly supplier of aggregate bank reserves. -By buying or selling securities in the market through an open market operation (OMO), the Fed could increase or decrease the supply of reserves in order to lower or raise the market federal funds rate.

Quantitative Easing

-During the financial crisis, the Fed lowered its policy target close to zero, and engaged in quantitative easing making large-scale asset purchases to increase the supply of reserves far beyond the level needed to keep the federal funds rate near zero. -Policymakers began specifying a target range.

The Taylor Rule (continued)

-Economists and central bankers believe that the personal consumption expenditure (PCE) index is a more accurate measure of inflation. Using the Fed's inflation target of 2% and assuming the natural rate of interest is 2%, the neutral target federal funds rate is 4 percent. -For the output gap, the usual choice the percentage by which GDP deviates from a measure of its trend, or potential. -When financial conditions are much stronger, or weaker than usual policymakers seeking to stabilize the economy may set an interest-rate target that differs substantially from the Taylor rule. -Uncertainty about the natural rate of interest. -There is a lack of real-time data.

Inflation Targeting

-Focuses on the objective of low and stable inflation. -It is a monetary policy strategy that involved public announcement of a numerical inflation target and underscores the central bank's commitment to price stability. -When the target is credible, inflation will be low, but above zero. -Long-term expectations of low inflation act to anchor low long-term interest rates and promote economic growth. -Hierarchical mandate in which price stability comes first and everything else comes second. (The ECB, Australia, Chile, South Africa, United Kingdom, and dozens of other countries) -Dual mandate in which the goal of price stability and maximum employment are equal. (The Fed)

Unconventional Policy Approaches

-Forward guidance is when the central bank communicates intentions regarding the future path of monetary policy. -Quantitative easing is when the bank supplies aggregate reserves beyond the quantity needed to lower the policy rate to its target (usually zero or lower). -Target asset purchases (TAP) is when the central bank alters the mix of assets it holds on its balance sheet in order to change their relative prices in a way that stimulates economic activity. -When the Fed refers to its unconventional policy of large-scale asset purchases, the purchases are QE, TAP, or both.

Tightening Monetary Policy Through the IOER Rate

-If there is an increase in the target range for the federal funds rate, the Fed will raise the IOER rate; raising the minimum rate at which banks are willing to lend. -This allows the FOMC to raise interest rates, tightening financial conditions, without altering the supply of reserves.

Monetary Policymakers' Goals Are:

-Low and stable inflation -High and stable growth -A stable financial system -Stable interest and exchange rates

Unconventional Policy Tooks

-Most central banks set a target for the overnight interbank lending rate. -However there are two circumstances when additional policy tools can play a useful stabilization role: 1) When lowering the target interest-rate to zero is not sufficient to stimulate the economy. 2) When an impaired financial system prevents conventional interest-rate policy from supporting economic growth.

A Guide to Central Bank Interest Rates: The Taylor Rule

-Policymakers both pick a specific target and choose when to implement it. -The Taylor Rule tracks the actual behavior of the target federal funds rate and relates it to the real interest rate, inflation, and output. -Target Fed Funds Rate = Natural Rate of Interest + Current Inflation + ½ (Inflation Gap) + ½ (Output Gap) -The natural rate of interest is the real short-term interest rate that prevails when the economy is using resources normally. -Taylor originally used 2 percent, which is close to the average real short-term rate. -The inflation is current inflation minus an inflation target (both measured as percentages). -The output gap is the percentage deviation of current output (real GDP) from potential output. -When the current output is above potential output, the output gap is positive. -When inflation rises above its target level, the response is to raise interest rates. -When output falls below the target level, the response is to lower interest rates. -If the inflation is currently on target and there is no output gap, the target federal funds rate should be set at the natural rate of interest plus target inflation. -This means that higher inflation leads policymakers to raise the inflation-adjusted cost of borrowing, this slows the economy and reduces inflation.

The Market Federal Funds Rate

-Prior to the financial crisis, the target federal funds rate was the FOMC's primary policy instrument. -The federal funds rate is determined in the market and not controlled by the Fed. -The target federal funds rate are sent by the FOMC and the markets federal funds rate, which transactions between banks take place.

Should central banks aim to control inflation, the price level, or nominal GDP?

-Proponents of price-level, or nominal GDP targeting argue that policymakers gain the ability to raise expected inflation by more than inflation targeting would. -This would drive the real interest rate further down and stimulate economic expansion. -Advocates view this approach as more effective than quantitative easing at the effective lower bound. -Skeptics point to the uncertainty about the inflation rate under price-level and nominal GDP targeting. -Inflation uncertainty rises when the economy's trend rate of real economic growth unexpectedly changes. -GDP figures suffer from three problems that make initial figures less accurate: timeliness, seasonality, and revisions.

Reserve Requirements

-Since 1935, the Federal Reserve Board has the authority to set the reserve requirements, which are the minimum level of reserves banks must hold either as vault cash or on deposit at the Fed. -Changes in the reserve requirement affect the money multiplier and the quantity of money and credit circulating the economy. -In the U.S., the reserve requirement turns out to not be very useful.

The Federal Reserve's Conventional Policy Toolbox

-The Federal Reserve can alter the quantity of reserves that depository institutions hold. -The Fed usually sets policy by focusing its attention on prices, rather than quantities. -The Federal Reserve has four leading conventional policy tools, also known as policy instruments. -Collateralized lending has virtually replaced uncollateralized lending, which forms the basis for the federal funds rate.

The Reserve Requirement

-The level of balances a bank is required to hold either as vault cash or as a deposit at a Federal Reserve Bank. -Set by the Federal Reserve Board within a legally imposed range. -Influences the demand for reserves; not used to alter monetary policy.

Forward Guidance

-The simplest unconventional approach is for the central bank to provide forward guidance or guidance today about policy target rates in the future. They might express the intent to keep the policy target low for an extended period of time. -This could have a specific termination date, or duration could be dependent on some future change in economic conditions. -To stimulate economic activity, forward guidance aims at lowering the long-term interest rates that affect private spending. -To be effective, forward guidance needs to be credible. -The Fed has used forward guidance with increasing frequency and refinement.

The Fed usually sets policy by focusing its attention on prices, rather than quantities.

Concentrates on the interest rate at which banks borrow and lend reserves overnight and the interest rate that the Fed pays on reserves that banks hold at the central bank.

The Implementation of the Taylor Rule

Requires Four Inputs: -The natural rate of interest -A measure of inflation -A measure of the inflation gap -A measure of the output gap

The Federal Reserve can alter the quantity of reserves that depository institutions hold.

Reserves are injected into the banking system through an increase in the size of the Fed's balance sheet, either because of a decision by the Fed or to buy securities or because of a bank's decisions to borrow from the Fed.

Making an Effective Exit

-Central banks have several policy options that allow them to raise interest rates without reducing the level of reserve supply or changing the composition of the balance sheet. -To tighten policy, the Fed raises the IOER rate. -Paying interest on reserves allows a central bank to control both price and quantity. -Price: It can adjust the target short-term interest rate (or range) and IOER rate without changing the size or composition of its balance sheet. -Quantity: It can adjust the size and composition of its balance sheet without changing the target short-term rate or IOER rate. -This means the central bank can change its balance sheet in a fashion consistent with financial stability while keeping inflation under control.

Policymakers then proceeded to develop and use a variety of unconventional policy tools.

-Massive purchases of risky assets in fragile markets. -Communicating its intent to keep interest rates low over an extended period.

Quantitative Easing

-QE occurs when the central bank expands the supply of aggregate reserves beyond the level that would be needed to maintain its policy rate target. -The central bank buys assets, thereby expanding its overall balance sheet. -At a market federal funds rate equal to the interest on excess reserves, an addition to aggregate reserves no longer reduces the funds rate. -The Fed can add limitlessly to reserves without affecting the market federal funds rate. -It is difficult to predict the effects of QE. -Fed policymakers argue their balance sheet expansion helped to lower long-term interest rates, but there is disagreement on the impacts. -The mechanism by which QE affects economic prospects is not clear. -An increase in the supply of reserves (QE) may simply lead banks to hold more of them rather than provide additional loans. -One mechanism is that QE can add credibility to a policymaker's promise to keep interest rates low. -Announcements of an expansion of aggregate reserves (QE) could lower bond yields by extending the time horizon over which bondholders expect a zero policy rate. -QE may reinforce the impact of forward guidance. -A problem with QE is that central banks do not know how much is needed to be effective. -QE can be a powerful tool for central bankers to prevent a sustained deflation, especially when conventional policy tools have been exhausted. -The first and largest application since the Great Depression occurred immediately after the Lehman failure in September 2008.

Target Asset Purchases

-Targeted asset purchases (TAP) shift the composition of the balance sheet toward selected assets in order to boost their relative price and stimulate economic activity. -The central bank's actions can influence both the cost and availability of credit. -In the absence of private demand for the risky asset, the central bank's purchase makes credit available where none existed. -The impact of TAP is likely to be greater in thin illiquid markets. And to be larger the bigger the difference between the yield on the asset that the central bank buys and the yield on the asset that the central bank sells. -By altering the relative supply of such assets to private investors, TAP narrows their interest rate differences. -In buying more than $1.8 trillion in MBS and more than $2 trillion in long-term Treasury debt. the central bank's goal was to lower yields on mortgages and other long term bonds. -A central bank cannot reliably anticipate the impact of TAP on the cost of credit. In normal times a central bank typically avoids such direct allocation of credit. -They promote competition rather than picking winners. -TAP purposely deviates from such asset neutrality in order to influence relative prices. -Exiting from TAP is probably also more difficult than unwinding QE. -TAP assets are generally harder to sell than short-term Treasuries. -The central bank may not want to be able to get rid of them exactly when it wants. -Political influences can become important if the Fed is hindered from selling specific assets for fear of raising the costs of a particular class of borrowers.

When QE and TAP have vastly expanded the amount of reserves and assets on the central bank's balance sheet...

-The central bank may need to sell a large volume of assets to reduce the reserve supply sufficiently to raise the policy rate target. -But, QE and TAP assets are typically more difficult to sell. -A central bank may be unable to sell assets and withdraw reserves from the banking system rapidly enough to hike the policy interest rate when it desires.

The Interest Rate on Excess Reserves (IOER rate)

-The interest paid by the Fed on reserves that banks hold in their accounts in excess of reserve requirements. -Announced by the FOMC as a rate to be paid on all excess reserves. -Changes interest rates at which banks will lend and borrow.

The Target Federal Funds Rate

-The interest rate at which banks borrow overnight from each other or from other intermediaries. -Announced by the FOMC as the target range for the market federal funds rate. -It influences interest rates throughout the economy.

The Discount Rate

-The interest rate charged by the Fed on its loans to banks. -These loans provide liquidity to banks as they are used to stabilize the financial system rather than as a tool to alter day-to-day monetary policy. -Set by the Reserve Banks, subject to approval by the Federal Reserve Board, at a premium over the interest rate in excess reserves (IOER rate). -Provides liquidity to banks in times of crisis; not used to alter monetary policy.

A consensus has developed among monetary policy experts that:

-The reserve requirement is not useful as an operational instrument. -Central bank lending is necessary to ensure financial stability. -Short-term interest rates are the conventional tool to use to stabilize short-term fluctuations in prices and output.

The Federal Reserve has four lending conventional policy tools, also known as policy instruments.

-The target federal funds rate -The interest rate on excess reserves (IOER rate). -The discount rate -The reserve requirement

Desirable Features of a Policy Instrument

A good monetary policy instrument has three features: -It is easily observable by everyone, which ensures transparency in policymaking, which enhances accountability. -It is controllable and quickly changed. This is so an instrument can be adjusted quickly in the face of a sudden change in economic conditions is clearly more useful. -It is tightly linked to the policymakers' objectives. This is so the more predictable the impact of an instrument, the easier it will be for policymakers to meet their objectives.