chapter 15

economic growth

increases in the economy's output of goods and services over time.

The European System of Central Banks

The European System of Central Banks (ESCB), consisting of the European Central Bank (ECB) and the national central banks of all member states of the European Union, commenced operation in January 1999, following the signing of the Maastricht Treaty. Modeled on the law governing the German Bundesbank, the German central bank, the primary objective of the ESCB is to maintain price stability. As a secondary objective, the ESCB must also support the general economic policies of the European Union.

Some economists and policymakers were concerned, though, that the persistence of unconventional policies might have introduced distortions into the economy and the financial system that could lead to future economic instability. In particular, they were concerned that:

A prolonged period of very low nominal interest rates had resulted in unsustainably high prices of stocks, corporate and government bonds, and other assets. Low interest rates had reduced the return to saving and had made it more difficult for risk-averse investors to adequately save for retirement using bank certificates of deposits (CDs) and other low-risk assets. The Fed's continuing to hold trillions of dollars in financial assets was distorting prices and yields in financial markets, particularly the housing market, by removing from the market securities usually held by private investors.

Arguments in favor of the Fed using an explicit inflation target focus on four points:

Announcing explicit targets for inflation draws the public's attention to what the Fed can actually achieve in practice. Most economists believe that over the long run, monetary policy has a greater effect on inflation than on the growth of real output or employment. Establishing transparent inflation targets for the United States provides an anchor for inflationary expectations. If households, firms, and participants in financial markets believe that the Fed will hit an annual inflation target of 2%, they will expect that if inflation was temporarily lower or higher, it will eventually return to the target rate. Inflation targets promote accountability for the Fed by providing a yardstick against which its performance can be measured. Inflation targeting potentially provides the Fed with another monetary policy tool. If the Fed raises its target for the inflation rate—and if participants in financial markets believe the Fed can hit its new, higher target and raise their expectations of the inflation rate—then for any given level of the nominal interest rate, the real interest rate will be lower. During 2016, some economists and policymakers suggested that the Fed raise its inflation target from 2% to 4%. With nominal interest rates at historically low levels, these economists saw an increase in the expected inflation rate as the only way to further reduce real interest rates.

primary credit

Banks may use primary credit for any purpose and do not have to seek funds from other sources before requesting a discount window loan from the primary credit facility, or standing lending facility.

The Fed needed both of these monetary policy tools because there are two distinct groups of financial institutions that borrow and lend in the federal funds market:

Depository institutions, such as commercial banks and savings and loans, that are eligible to borrow and lend in the federal funds market, and whose deposits with the Fed receive interest. Financial institutions such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBs) that are eligible to borrow and lend in the federal funds market, but whose deposits with the Fed do not receive interest. (Congress established the Federal Home Loan Bank System in 1932 to lend to savings and loans as the Federal Reserve does to commercial banks. The 12 district FHLBs sell debt in financial markets and use the funds to make loans, called advances, to member financial institutions. In recent years, the FHLBs have made substantial overnight loans in the federal funds market.)

high employment

Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978 to make explicit the federal government's commitment to achieving high employment and price stability.

Discount Lending During the Financial Crisis of 2007-2009

Federal Reserve Act authorized the Fed in "unusual and exigent circumstances" to lend to any "individual, partnership, or corporation" that could provide acceptable collateral and could demonstrate an inability to borrow from commercial banks.

Taylor Rule

Federal funds rate target=Current inflation rate+Equilibrium realfederal funds rate+(1/2×Inflation gap)+(1/2×Output gap).

The Bank of Japan

In the aftermath of the first OPEC oil shock in 1973, Japan experienced an inflation rate in excess of 20%. This high inflation rate led the Bank of Japan (BOJ) to adopt explicit money growth targets. In particular, beginning in 1978, the BOJ announced targets for an aggregate corresponding to M2. Following the 1979 oil price shock, the central bank reduced money growth. The gradual decline in money growth over the period from 1978 through 1987 was associated with a faster decline in inflation than the United States experienced.

During the financial crisis, the Fed introduced the following three new policy tools connected with bank reserve accounts.

Interest on reserve balances. In October 2008, the Fed introduced a new tool when it began for the first time to pay interest on banks' required reserve and excess reserve deposits.3 This interest rate is called the IOER, which stands for interest rate on excess reserves. Reserve requirements impose an implicit tax on banks because banks could otherwise receive interest on the funds by lending them out or by investing them. The Fed reduces the size of this tax by paying interest on reserve balances. The Fed also gains a greater ability to influence banks' reserve balances. By raising the interest rate it pays, the Fed can increase banks' holdings of reserves, potentially restraining banks' ability to extend loans and increase the money supply. By reducing the interest rate, the Fed can have the opposite effect. Finally, the interest rate the Fed pays on reserves can help put a floor on short-term interest rates because banks will typically not lend funds elsewhere at an interest rate lower than the rate they can earn on reserves deposited with the Fed. Overnight reverse repurchase agreement facility. As we will discuss in the next section, the Fed's traditional means of raising short-term interest rates was to raise its target for the federal funds rate—the rate banks charge each other on overnight loans—by using open market sales to reduce the level of reserves in the banking system. But with banks still holding trillions of dollars of excess reserves years after the financial crisis, the Fed could not use open market sales to increase its target for the federal funds rate. Instead, in December 2015, when the Fed raised its target for the federal funds rate, it did so by increasing the interest rate it paid banks on reserves and the interest rate it offered on reverse repurchase agreements. We will discuss the details of this process in Section 15.3. For now, recall that a repurchase agreement (or repo) is a short-term loan backed by collateral. With a repurchase agreement, the Fed buys a security from a financial firm, which promises to buy it back from the Fed the following day. With a reverse repurchase agreement (sometimes called a matched sale-purchase agreement or reverse repo), the Fed does the opposite: It sells a security to a financial firm while at the same time promising to buy the security back the next day. In effect, the Fed is borrowing funds overnight from the firm that purchases the security. By raising the interest rate it is willing to pay on these loans, the Fed reduces the willingness of the firms it deals with in these transactions—its counterparties—to lend at a lower rate. The Fed refers to overnight reverse repurchase agreements as ON RRPs and the interest rate on these securities as the ON RRP rate. Although this procedure is more complex than the Fed's traditional means of raising the target for the federal funds rate, it is an effective way for the Fed to achieve that target at a time when banks are holding very large levels of excess reserves. Term deposit facility. In April 2010, the Fed announced that it would offer banks the opportunity to purchase term deposits, which are similar to the certificates of deposit that banks offer to households and firms. The Fed offers term deposits to banks in periodic auctions. The interest rates are determined by the auctions and have been slightly above the interest rate the Fed offers on reserve balances. For example, in August 2016, the interest rate on the Fed's auction of $58 billion in 7-day term deposits was 0.51%, which was higher than the interest rate of 0.50% the Fed was paying on reserve deposits. The term deposit facility gives the Fed another tool in managing bank reserve holdings. The more funds banks place in term deposits, the less they will have available to expand loans and the money supply. The term deposit facility is the least important of the Fed's three new monetary policy tools.

Intermediate Targets

Intermediate targets are typically either monetary aggregates, such as M1 or M2, or interest rates. The Fed can use as an intermediate target either a short-term interest rate, such as the interest rate on Treasury bills, or a long-term interest rate, such as the interest rate on corporate bonds or residential mortgages. The Fed typically chose an intermediate target that it believed would directly help it to achieve its goals.

The Fed's main policy instruments have been reserve aggregates, such as total reserves or nonborrowed reserves, and the federal funds rate. We can briefly assess how well these instruments meet the Fed's three criteria:

Measurable. The variable must be measurable in a short time frame to overcome information lags. The Fed exercises significant control over both reserve aggregates and the federal funds rate and can accurately measure them hour by hour if it needs to. Controllable. Although the Fed lacks complete control over the level of reserve aggregates and the federal funds rate because both depend on banks' demands for reserves, the Fed has the tools to keep both variables close to whatever target it selects. However, since December 2008, the Fed has chosen a range rather than a single number as its target for the federal funds rate. Predictable. The Fed needs a policy instrument that has a predictable effect on its policy goals. The effect of a change in either reserves or the federal funds rate on goals such as economic growth or price stability is complex. This complexity is one reason the Fed at one time relied on intermediate targets. Because it is not clear whether reserves or the federal funds rate best meets this last criterion, economists continue to discuss which policy instrument is best, although this discussion has not been at the center of debates over monetary policy in recent years.

Fed's three traditional policy tools:

Open market operations are the Fed's purchases and sales of securities in financial markets. Traditionally, the Fed concentrated on purchases and sales of Treasury bills, with the aim of influencing the level of bank reserves and short-term interest rates. During the financial crisis, the Fed began purchasing a wider variety of securities to affect long-term interest rates and to support the flow of credit in the financial system. Discount policy includes setting the discount rate and the terms of discount lending. When Congress passed the Federal Reserve Act in 1913, it expected that discount policy would be the Fed's primary monetary policy tool. The discount window is the means by which the Fed makes discount loans to banks, and it serves as the channel to meet banks' short-term liquidity needs. Reserve requirements are the Fed's regulation requiring that banks hold a certain fraction of their checkable deposits as vault cash or deposits with the Fed.2 In Chapter 14, we saw that the required reserve ratio is a determinant of the money multiplier in the money supply process.

The Fed used this authority to set up several temporary lending facilities:

Primary Dealer Credit Facility. Under this facility, primary dealers could borrow overnight using mortgage-backed securities as collateral. This facility was intended to allow the investment banks and large securities firms that are primary dealers to obtain emergency loans. The facility was established in March 2008 and closed in February 2010. Term Securities Lending Facility. Under this facility, the Fed would loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities. By early 2008, selling mortgage-backed securities had become difficult. This facility was intended to allow financial firms to borrow against those illiquid assets. It was established in March 2008 and closed in February 2010. Commercial Paper Funding Facility. Under this facility, the Fed purchased three-month commercial paper issued by nonfinancial corporations. When Lehman Brothers defaulted on its commercial paper in October 2008, many money market mutual funds suffered significant losses. As investors began redeeming their shares in these funds, the funds stopped buying commercial paper. Many corporations had come to rely on selling commercial paper to meet their short-term financing needs, including funding their inventories and their payrolls. By buying commercial paper directly from these corporations, the Fed allowed them to continue normal operations. This facility was established in October 2008 and closed in February 2010. Term Asset-Backed Securities Loan Facility (TALF). Under this facility, the Federal Reserve Bank of New York extended three-year or five-year loans to help investors fund the purchase of asset-backed securities. These securities are securitized consumer and business loans, apart from mortgages. For instance, some asset-backed securities consist of consumer automobile loans that have been bundled together as a security to be resold to investors. Following the financial crisis, the market for asset-backed securities largely dried up. This facility was established in November 2007, and the last loans were made in June 2010.

Some economists and policymakers were critical of the Fed's decision to adopt an explicit inflation target, however. Opponents of inflation targets make five points:

Rigid numerical targets for inflation diminish the flexibility of monetary policy to address other policy goals. Because monetary policy affects inflation with a lag, inflation targeting requires that the Fed depend on forecasts of future inflation, uncertainty about which can create problems for the conduct of policy. Holding the Fed accountable only for a goal of low inflation may make it more difficult for elected officials to monitor the Fed's support for good economic policy overall. Uncertainty about future levels of output and employment can impede economic decision making in the presence of an inflation target. That is, inflation targets may increase uncertainty over whether the Fed will take prompt action to return the economy to full employment following a recession. Using the inflation target as another monetary policy tool could potentially be economically destabilizing. As the experience of the 1970s shows, once a higher inflation rate becomes embedded in the expectations of households and firms, it can be difficult to reduce the expectations again. In the context of 2016, forcing real interest rates lower ran the risk of increasing distortions in the financial system, possibly fueling speculative asset bubbles.

The Bank of Canada

The Bank of Canada, like the U.S. Fed, became increasingly concerned about inflation during the 1970s. In 1975, the Bank of Canada announced a policy of gradually reducing the growth rate of M1. By late 1982, M1 targets were no longer used. In 1988, John Crow, then governor of the Bank of Canada, announced the bank's commitment to price stability by announcing a series of declining inflation targets.

Operation Twist.

The policy's name reflects its goal of twisting the yield curve by increasing short-term interest rates and lowering long-term interest rates. Because Operation Twist attempted to directly reduce long-term interest rates through bond purchases, it was similar in its effects to quantitative easing.

seasonal credit

consists of temporary, short-term loans to satisfy seasonal requirements of smaller banks in geographic areas where agriculture or tourism is important. For example, by using these loans, a bank in a ski resort area in Vermont won't have to maintain excess cash or sell loans and investments to meet the borrowing needs of local firms during the winter months.

Open market operations have several benefits that the Fed's other traditional policy tools—discount policy and reserve requirements—lack:

control, flexibility, and speed of implementation.

frictional unemployment

enables workers to search for positions that maximize their well-being.

secondary credit

intended for banks that are not eligible for primary credit because they have inadequate capital or low supervisory ratings. This type of credit is often used for banks that are suffering from severe liquidity problems, including those that may soon be closed.

the Fed has relied on two types of targets:

policy instruments—sometimes called operating targets—and intermediate targets.

Structural unemployment

refers to unemployment that is caused by changes in the structure of the economy, such as shifts in manufacturing techniques toward automation, increased use of computer hardware and software in offices, and increases in the production of services instead of goods.

The Bank of England

the Bank of England (BOE) responded to rising inflation in the early 1970s by announcing that it would adopt targets for money supply growth. In response to accelerating inflation in the late 1970s, the government of Prime Minister Margaret Thatcher formally introduced in 1980 a strategy for gradual deceleration of money supply growth. Beginning in 1983, the BOE shifted its emphasis toward targeting growth in the monetary base (again with an eye toward a gradual reduction in the rate of growth of the money supply). In 1992, the United Kingdom adopted inflation targets, which are set by the chancellor of the Exchequer (a position similar to the secretary of the Treasury in the United States) rather than by the BOE.

cyclical unemployment

which is unemployment associated with business cycle recessions.

The debate over the central bank policy of negative interest rates centered on two questions:

(1) Was a policy of negative interest rates likely to result in short-run increases in output and employment? and (2) Was the policy likely to introduce distortions in the financial system?

The Fed has set six monetary policy goals

Price stability High employment Economic growth Stability of financial markets and institutions Interest rate stability Foreign exchange market stability

Policy Instruments, or Operating Targets

The Fed controls intermediate target variables, such as the mortgage interest rate or M2, only indirectly because the decisions of households, firms, and investors also influence these variables.

Categories of Discount Loans

The Fed's discount loans to banks fall into three categories: (1) primary credit, (2) secondary credit, and (3) seasonal credit.