Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Chapter Eighteen
Monetary Policy: Stabilizing the
Domestic Economy
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
• There are three interest rates:
• The federal funds rate,
• The discount rate, and
• The deposit rate.
• These are the primary tools of monetary policy
during normal times.
• In a financial crisis, central banks may also
adjust the size and composition of their balance
sheet.
18-2
Introduction
• Interest rates play a central role in all of our
lives.
• They are the cost of borrowing and the reward for
lending.
• Higher rates restrict growth of credit.
• The business press is constantly speculating
about whether the FOMC will change its target.
18-3
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
Fed hit the zero bound on the nominal federal
funds rate.
• Banks can always hold cash paying zero interest.
• They will never choose to lend their reserves at a
negative nominal rate.
• The nominal policy rate therefore faces a zero
bound: it will never fall below zero.
18-4
Introduction
• Even setting the federal fund rate target at
essentially zero wasn’t enough to stabilize the
economy.
• The crisis had undermined the willingness and
ability of major financial intermediaries to
lend.
• In this environment the Fed moved to
substitute itself for dysfunctional
intermediaries and markets.
• This significantly altered the Fed’s balance sheet.
18-5
18-6
Introduction
• To steady the financial system and the
economy after the crisis, the Fed utilized its
three principal conventional policy tools:
• The federal funds rate target,
• The rate for discount window lending, and
• The deposit rate.
• They did so to the fullest extent possible to
support economic activity.
18-7
Introduction
• Policymakers then proceeded to develop and
use a variety of unconventional policy tools
including:
• Commitments to keep interest rates low over time,
and
• Massive purchases of risky assets in thin, fragile
markets.
• These unconventional measures added
meaningfully to the conventional actions.
18-8
Introduction
• In this chapter we will:
• See how the Fed uses its policy tools, both conventional
and unconventional to achieve economic stability.
• See that those tools are quite similar to those of other
central banks.
• Focus on three links:
• Between the central bank’s balance sheet and its
policy tools;
• Between the policy tools and monetary policy
objectives; and
• Between monetary policy and the real economy.
18-9
The Federal Reserve’s Conventional
Policy Toolbox
• In looking at day-to-day monetary policy, it is
essential that we understand the institutional
structure of the central bank and financial
markets.
• We will begin with the Fed and financial
markets in the U.S.
• In the next section, we will look at the ECB’s
operating procedures to see how they differ.
18-10
The Federal Reserve’s Conventional
Policy Toolbox
•
The Fed has four conventional monetary
policy tools, also known as monetary policy
instruments:
1.
2.
3.
4.
•
The target federal funds rate,
The discount rate,
The deposit rate, and
The reserve requirement.
Each of these tools are related to several of
the central bank’s functions and objectives.
18-11
The Federal Reserve’s Conventional
Policy Toolbox
18-12
The Target Federal Fund Rate and
Open Market Operations
• The target federal fund rate is the FOMC’s
primary policy instrument.
• The federal funds rate is the rate at which
banks lend reserves to each other over night.
• It is determined in the market and not controlled by
the Fed.
• We will distinguish between the target federal
funds rate set by the FOMC and the market
federal funds rate, at which transactions
between banks take place.
18-13
The Target Federal Fund Rate and
Open Market Operations
• On any given day, banks target the level of
reserves they would like to hold at the close of
business.
• That may leave them with more or less reserves
than they want.
• This gives rise to a market for reserves.
• Some banks can lend out excess reserves.
• Some banks will borrow to cover a shortfall.
18-14
The Target Federal Fund Rate and
Open Market Operations
• Without this market, banks would need to hold
substantial quantities of excess reserves as
insurance against shortfalls.
• These transactions are all bilateral agreements
between two banks.
• Loans are unsecured so the borrowing bank
must be credit worthy in the eyes of the lending
bank.
18-15
The Target Federal Fund Rate and
Open Market Operations
• If the Fed wanted to, it could force the market
federal funds rate to equal the target rate.
• However, policymakers believe that the federal
funds market provides valuable information
about the health of specific banks.
• So the Fed allows the federal funds rate to
fluctuate around its target in a channel or
corridor defined by the discount rate and the
deposit rate.
18-16
The Target Federal Fund Rate and
Open Market Operations
• When the federal fund rate climbs to the
discount rate, banks may borrow from the Fed
at the discount rate.
• When the market federal funds rate falls to the
deposit rate, banks can deposit their excess
reserves at the Fed at the deposit rate.
• The Fed can adjust the width of the so-called
channel around the target federal funds rate.
18-17
The Target Federal Fund Rate and
Open Market Operations
• The Fed targets an interest rate at the same
time that it wants to allow an interbank lending
market to flourish.
• Instead of fixing the interest rate, the Fed
controls the federal funds rate by manipulating
the quantity of reserves.
• The Fed does this by using open market
operations.
18-18
The Target Federal Fund Rate and
Open Market Operations
• We can use a standard supply-and-demand
graph to analyze the market in which banks
borrow and lend reserves.
• The demand curve for reserves is downward
sloping.
• However, when the federal funds rate in the
market drops to the deposit rate, banks are
willing to hold any amount of reserves supplied
beyond this level.
• So the demand curve turns flat.
18-19
The Target Federal Fund Rate and
Open Market Operations
• Keeping the market federal funds rate at the
target means balancing supply and demand for
reserves at that target rate.
• The staff of the Open Market Trading Desk
does this by:
• Estimating the demand for reserves at the target rate
each morning, and
• Supplying that quantity for the day.
• This means the daily supply for reserves is
vertical until the market federal funds rate
reaches the discount rate.
18-20
The Target Federal Fund Rate and
Open Market Operations
18-21
The Target Federal Fund Rate and
Open Market Operations
• Within a day, the federal funds rate can
fluctuate in a range from the deposit rate to the
discount rate.
• As the reserve demand shifts, the Fed staff will
use open market operations to shift the daily
reserve supply curve to accommodate the
change.
• This ensures that the market federal funds rate stays
near the target.
18-22
The Target Federal Fund Rate and
Open Market Operations
• An increase in reserve
demand is met by an open
market purchase.
• The vertical portion of
reserve supply shifts to
the left to keep the federal
funds rate at the target
level.
18-23
The Target Federal Fund Rate and
Open Market Operations
• We can compare the FOMC’s target rate with
the market rate over the last two decades.
• We can see how well the Fed’s staff has met its
objective.
• Figure 18.4 plots both the target federal funds
rate and the market federal fund rate beginning
in 1992.
18-24
The Target Federal Fund Rate and
Open Market Operations
• We can see that the market rate was close to
the target on most days after 2000.
• Changes in the reserve accounting rules in
1998 and improvements in information systems
made it easier for the Open Market Trading
Desk to estimate reserve demand.
• The use of the discount rate as a daily cap on
the funds rate after 2002 appears to have
stabilized the market rate even further.
• The 2007-2009 crisis introduced new targeting
errors.
18-25
The Target Federal Fund Rate and
Open Market Operations
18-26
• The Federal Funds Rate is the overnight
lending rate.
• Long-term interest rates = average of expected
short-term interest rates + the risk premium.
• When the expected future path of the federal
funds rate changes, long-term interest rates we
all care about change.
18-27
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 ultimately
• Interest rates.
• However, lending by the Federal Reserve
Banks to commercial banks, called discount
lending, is usually small aside from crisis
periods.
18-28
Discount Lending, the Lender of Last
Resort, and Crisis Management
• Yet, 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.
• Recall that crises were the primary impetus for
the creation of the Federal Reserve in the first
place.
18-29
Discount Lending, the Lender of Last
Resort, and Crisis Management
• The idea was that some central government
authority should be capable of providing funds
to sound banks to keep them from failing
during financial panics.
• The central bank is therefore the lender of last
resort:
• Making loans to banks when no none else will or
can.
18-30
Discount Lending, the Lender of Last
Resort, and Crisis Management
• But, a bank is supposed to show that it is sound
to get a loan in a crisis.
• This means having assets the central bank will take
as collateral.
• A bank that does not have assets it can use as
collateral for a discount loan is a bank that
should probably fail.
18-31
Discount Lending, the Lender of Last
Resort, and Crisis Management
• For most of its history, the Fed loaned reserves
to banks at a rate below the target federal fund
rate.
• Borrowing from the Fed was cheaper than
borrowing from another bank.
• But no one borrowed.
• The Fed required banks to exhaust all other sources
of funding before they applied for a loan.
18-32
Discount Lending, the Lender of Last
Resort, and Crisis Management
• Banks that used discount loans regularly faced
the possibility of being denied loans in the
future.
• These rules created quite a disincentive to
borrow from the Fed.
• By severely discouraging banks from borrowing,
the Fed destabilized the interbank market for
reserves causing some of the upward spikes in
Figure 18.4.
18-33
Discount Lending, the Lender of Last
Resort, and Crisis Management
• Because of this in 2002, officials instituted the
discount lending procedures in place today.
• The current discount lending procedures:
• Provide a mechanism for stabilizing the financial
system, and
• Help the Fed meet its interest-rate stability
objective.
18-34
Discount Lending, the Lender of Last
Resort, and Crisis Management
•
The Fed makes three types of loans:
1. Primary credit,
2. Secondary credit, and
3. Seasonal credit.
•
•
The Fed controls the interest rate on these
loans.
The banks decide how much to borrow.
18-35
Primary Credit
• Primary credit is extended on a very short-term
basis, usually overnight, to institutions that the
Fed’s bank supervisors deem to be sound.
• Banks seeking to borrow much post acceptable
collateral.
• The interest rate on primary credit is set at a
spread above the federal fund target rate called
the primary discount rate.
18-36
Primary Credit
• Primary credit is designed to provide additional
reserves at times when the open market staff’s
forecasts are off and so that the day’s reserve
supply falls short.
• The market federal funds rate will rise above the
FOMC’s target.
• Providing a facility through which banks can
borrow at a penalty rate above the target puts a
cap on the market federal funds rate.
18-37
Primary Credit
•
The system is designed both:
•
•
•
To provide liquidity in times of crisis, ensuring
financial stability, and
To keep reserve shortages from causing spikes in
the market federal funds rate.
By restricting the range over which the
market federal funds rate can move, this
system helps to maintain interest-rate
stability.
18-38
Secondary Credit
• Secondary credit is available to institutions that
are not sufficiently sound to qualify for
primary credit.
• The secondary discount rate is set about he
primary discount rate.
• There are two reason a bank might seek
secondary credit:
• A temporary shortfall of reserves, or
• They cannot borrow from anyone else.
18-39
Secondary Credit
• By borrowing in the secondary credit market, a
bank signals that it is in trouble.
• Secondary credit is for banks that are
experiencing longer-term problems that they
need some time to work out.
• Before the Fed makes the loan, it has to believe
that there is a good chance the bank will be
able to survive.
18-40
Seasonal Credit
• Seasonal credit is used primarily by small
agricultural banks in the Midwest to help in
managing the cyclical nature of farmers’ loans
and deposits.
• Historically, these banks had poor access to
national money markets.
• In recent years, however, there has been a
move to eliminate seasonal credit.
• There seems little justification for the practice
as they now have easy access to longer-term
loans from large commercial banks.
18-41
Reserve Requirements
• Since 1935, the Federal Reserve Board has had
the authority to set the reserve requirements.
• These 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 in the economy.
• However, the reserve requirement turns out not
to be very useful.
18-42
Reserve Requirements
• The reserve requirement is applied to two-week
average balances in account with unlimited
checking privileges--transaction deposits.
• This period ends every second Monday.
• The reserves a bank must hold are also
averaged over a two-week period, called the
maintenance period.
• This begins on the third Thursday after the end of
the computation period.
18-43
Reserve Requirements
• This means that the banks and the Fed both
know exactly what level of reserves every bank
is required to hold during given maintenance
period well before the period starts.
• All banks have 16 days to figure out their
deposit balances before they even need to start
holding reserves.
• This procedure is called lagged-reserve
accounting, and it makes the demand for
reserves more predictable.
18-44
Reserve Requirements
• In 1980, the Monetary Control Act changed the
rules slightly so that the Fed can now set the
reserve requirement ratio between 8 and 14
percent of these transactions deposits.
• Now that interest is paid on reserves, it is not
so costly to the banks.
• To help small banks, the law specifies a
graduated reserve requirement similar to
graduated income taxes.
18-45
Reserve Requirements
• In the beginning, reserves were required to
ensure banks were sound and to reassure
depositors that they could withdraw currency
on demand.
• Today the reserve requirement exists primarily:
• To stabilize the demand for reserves, and
• To help the Fed to maintain the market federal
funds rate close to target.
18-46
Reserve Requirements
• Before August 1998, the computation and
maintenance periods overlapped.
• Banks had to manage their deposits and
reserves at the same time.
• The result was a volatile market federal funds rate.
• Since the summer of 1998, things have calmed
down quite a bit.
18-47
• Numerous innovations have reduced the
demand for the monetary base.
• As the demand for the reserves disappears, will
monetary policy go with it?
• There are other countries who have eliminated
reserve requirements entirely, but retain
monetary policy control.
• Australia, Canada, and New Zealand, for example.
18-48
• They do it through what is called a “channel” or
“corridor” system that involves setting not only a target
interest rate, but also a lending and deposit rate: just as
the Fed and the ECB do.
• Banks in need of funds will never be willing to pay
more than the central bank’s lending rate, and
• Those that have excess funds will never be willing to
lend at a rate below the central bank’s deposit rate.
• This will continue to give monetary policymakers a
tool to influence the economy.
18-49
18-50
Operational Policy at the European
Central Bank
• Like the Fed’s, the ECB’s monetary policy
toolbox contains:
• An overnight interbank rate,
• A rate at which the central banks lends to
commercial banks,
• A reserve deposit rate, and
• A reserve requirement.
18-51
The ECB’s Target Interest Rate and
Open Market Operations
• While the ECB occasionally engages in
outright purchases of securities, it provides
reserves to the European banking system
primarily through refinancing operations:
• A weekly auction of two-week repurchase
agreements (repo) in which ECB, through the
National Central Banks, provides reserves to banks
in exchange for securities.
• The transaction is reversed two weeks later.
18-52
The ECB’s Target Interest Rate and
Open Market Operations
• The policy instrument of the ECB’s Governing
council is the minimum interest rate allowed at
these refinancing auctions,
• Which is called the main refinancing operations
minimum bid rate.
• We will refer to this minimum bid rate as the
target refinancing rate.
18-53
The ECB’s Target Interest Rate and
Open Market Operations
• In normal times, the main refinancing
operations provide banks with virtually all their
reserves.
• However, in the crisis of 2007-2009, the ECB
sought to steady financial markets by providing
most reserves through longer-term refinancing.
18-54
The ECB’s Target Interest Rate and
Open Market Operations
•
There are some differences between the
ECB’s refinancing operations and the Fed’s
daily open market operations.
1. The operations are done at all the National Central
Banks (NCBs) simultaneously.
2. Hundreds of European banks participate in the
ECB’s weekly auctions.
3. Because of the differences in financial structure in
different countries, the collateral that is accepted
in refinancing operations differs from country to
country.
18-55
The ECB’s Target Interest Rate and
Open Market Operations
• Some of the National Central Banks in the
Eurosystem accept a broad range of collateral,
including not only government-issued bonds
but also privately issued bonds and bank loans.
• When the rating on government bonds of one
euro-area country fell below investment grade
in 2010, the ECB continued to accept them as
collateral.
18-56
The ECB’s Target Interest Rate and
Open Market Operations
• The ECB engages in both:
• Monthly long-term refinancing operations in which
is offers reserves for three months; and
• Infrequent small operations that occur between the
main refinancing operations.
18-57
The Marginal Lending Facility
• The ECB’s Marginal Lending Facility is the
analog to the Fed’s primary credit facility.
• Through this the ECB provides overnight loans
to banks at a rate that is normally well above
the target-refinancing rate.
• The spread between the marginal lending rate
and the target refinancing rate is set by the
Governing Council.
18-58
The Marginal Lending Facility
• Commercial banks initiate these borrowing
transactions when they face a reserve
deficiency that they cannot satisfy more
cheaply in the marketplace.
• Banks do borrow regularly, and on occasion
the amounts they borrow are large.
• The ECB’s system, based on the German
Bundesbanks, was the model for the 2002
redesign of the Fed’s discount window.
18-59
The Deposit Facility
• Banks with excess reserves at the end of the day can
deposit them overnight in the ECB’s Deposit Facility at
a interest rate substantially below the target-refinancing
rate.
• Again, the spread is determined by the Governing
Council.
• The existence of the deposit facility places a floor on
the interest rate that can be charged on reserves.
• The ECB’s deposit facility was the model for the Fed’s
deposit rate introduced in October 2008.
18-60
Reserve Requirements
• The ECB requires that banks hold minimum
reserves based on the level of their liabilities.
• The reserve requirement of 2% is applied to
checking accounts and some other short-term
deposits.
• Deposit level are averaged over a month, and
reserve levels must be held over the following
month.
18-61
Reserve Requirements
• The ECB pays interest on the required reserves.
• The rate:
• Is based on the interest rate from the weekly
refinancing auctions, averaged over a month,
and
• Is designed to be very close to the interbank rate.
• This means that the cost of meeting the reserve
requirement is low.
18-62
Reserve Requirements
• The European system is designed to give the
ECB tight control over the short-term money
market in the euro area.
• And it usually works well.
• The overnight cash rate is the European analog
to the market federal funds rate.
• Even during the crisis, the overnight cash rate
remained within the band formed by the
marginal lending rate and the deposit rate.
18-63
Reserve Requirements
18-64
Reserve Requirements
• This pattern contrasts starkly with that of the
U.S. market federal funds rate before 2002.
• As the Fed gradually introduced a version of
the ECB’s conventional policy toolkit, the fund
rate was more than 100 basis points away from
the target on only three occasions between
2002 and early 2010.
• The European system is clearly more
successful in keeping the short-term rate close
to target.
18-65
• The Fed officially recognizes several other
unconventional tools, or facilities, which are
described in Table 18.2.
• Note that Table 18.2 leaves out several
important mechanisms that the Fed used
extensively in the crisis.
• For example, it purchased more than $1 trillion of
mortgage-backed securities.
• The Fed also committed to keeping its policy rate
low for an extended period in order to influence
long-term interest rate expectations.
18-66
18-67
Linking Tools to Objectives:
Making Choices
• Monetary policymakers’ goals are:
•
•
•
•
Low and stable inflation,
High and stable growth,
A stable financial system, and
Stable interest and exchange rates.
• These are given to them by their elected
officials.
• But day-to-day policy is left to the technicians.
18-68
Linking Tools to Objectives:
Making Choices
•
A consensus has developed among monetary
policy experts that:
1. The reserve requirement is not useful as an
operational instrument,
2. Central bank lending is necessary to ensure
financial stability, and
3. Short-term interest rates are the tool to use to
stabilize short-term fluctuations in prices and
output.
18-69
Desirable Features of a Policy
Instrument
•
A good monetary policy instrument has three
features:
1. It is easily observable by everyone.
2. It is controllable and quickly changed.
3. It is tightly linked to the policymakers’
objectives.
18-70
Desirable Features of a Policy
Instrument
• It is important that a policy instrument be
observable to ensure transparency in
policymaking, which enhances accountability.
• An instrument that can be adjusted quickly in
the face of a sudden change in economic
conditions is clearly more useful than one that
cannot.
• And the more predictable the impact of an
instrument, the easier it will be for
policymakers to meet their objectives.
18-71
Desirable Features of a Policy
Instrument
• The reserve requirement does not meet these
criteria because banks cannot adjust their
balance sheets quickly.
• So what other options do we have?
• Well there are the other components of the central
bank’s balance sheet.
• But how do we choose between controlling
quantities and controlling prices?
18-72
Desirable Features of a Policy
Instrument
• From 1979 to 1982, the Fed targeted reserves
rather than interest rates.
• We saw interest rates that would not have been
politically acceptable if they had been announced as
targets.
• Since they said they were targeting reserves, the
Fed escaped responsibility for the high interest
rates.
• When inflation had fallen and interest rates
came back down, the FOMC reverted to
targeting the federal funds rate.
18-73
Desirable Features of a Policy
Instrument
• There is a very good reason the vast majority
of central banks in the world today choose to
target an interest rate rather than some quantity
on their balance sheet.
• With reserve supply fixed, a shift in reserve
demand changes the federal funds rate.
• If the fed chooses to target the quantity of
reserves, it gives up control of the federal funds
rate.
• Targeting reserves creates interest rate
volatility.
18-74
Desirable Features of a Policy
Instrument
• A shift in reserve demand
would move the market federal
funds rate.
• Reserve targets make interest
rates volatile.
• The federal funds rate is the
link from the financial sector to
the real economy.
• Targeting reserves could
destabilize the real economy.
18-75
Desirable Features of a Policy
Instrument
• Interest rates are the primary linkage between
the financial system and the real economy.
• Stabilizing growth means keeping interest rates
from being overly volatile.
• This means keeping unpredictable changes in
the reserve demand from influencing interest
rates and feeding into the real economy.
• The best way to do this is to target interest rates.
18-76
• Inflation targeting bypasses intermediate targets and
focuses on the final objective.
• Components:
• Public announcement of numerical target,
• Commitment to price stability as primary objective, and
• Frequent public communication.
• Inflation targeting increases policymakers’
accountability and helps to establish their credibility.
• The result is not just lower and more stable inflation
but usually higher and more stable growth as well.
18-77
Operating Instruments and
Intermediate Targets
• Central bankers sometimes use the terms
operating instrument and intermediate target.
• Operating instruments refer to actual tools of
policy.
• These are instruments that the central bank controls
directly.
• The term intermediate targets refers to
instruments that are not directly under their
control but lie somewhere between their
policymaking tools and their objectives.
18-78
Operating Instruments and
Intermediate Targets
18-79
Operating Instruments and
Intermediate Targets
• The monetary aggregates are a prime example
of intermediate targets.
• The idea behind targeting M2, for example, is
that changes in the monetary base affect the
monetary aggregates before they influence
inflation or output.
• So targeting M2, central bankers can more
effectively met their objectives.
• Money growth is just an indicator easily
monitored by the public.
18-80
Operating Instruments and
Intermediate Targets
• Central bankers have largely abandoned
intermediate targets.
• Circumstances may change in ways that make
an intermediate target unworkable.
• So while people still do discuss intermediate
targets, it is hard to justify using them.
• Policymakers instead focus on how their actions
directly affect their target objectives.
18-81
A Guide to Central Bank Interest
Rates: The Taylor Rule
• 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 =
2 + Current Inflation
+ ½ (Inflation gap)
+ ½ (Output gap)
18-82
A Guide to Central Bank Interest
Rates: The Taylor Rule
• This assumes a long-term real interest rate of 2
percent.
• The inflation gap is current inflation minus an
inflation target.
• The output gap is current GDP minus its
potential level:
• The percentage deviation of current output from
potential output.
18-83
A Guide to Central Bank Interest
Rates: The Taylor Rule
• For example, if
• Inflation is currently 3 percent, and
• GDP equals its potential level so there is no output
gap, then
• The target federal funds rate should be set at 2 + 3 +
½ = 5 ½ percent.
18-84
A Guide to Central Bank Interest
Rates: The Taylor Rule
• 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 inflation is currently on target and there is no
output gap,
• The target federal funds rate should be set at its
neutral rate of target inflation plus 2.
18-85
A Guide to Central Bank Interest
Rates: The Taylor Rule
• The Taylor rule has some interesting
properties.
• The increase in current inflation feeds one for one
into the target federal funds rate; however,
• The increase in the inflation cap is halved.
• A 1 percentage point increase in the inflation
rate raises the target federal funds rate 1½
percentage points.
18-86
A Guide to Central Bank Interest
Rates: The Taylor Rule
• The Taylor rule tells us that for each
percentage point increase in inflation,
• The real interest rate, equal to the nominal interest
rate minus expected inflation, goes up half a
percentage point.
• This means that higher inflation leads
policymakers to raise the inflation-adjusted
cost of borrowing.
• This then slows the economy and ultimately reduces
inflation.
18-87
A Guide to Central Bank Interest
Rates: The Taylor Rule
• The Taylor rule also states that for each
percentage point output is above potential:
• Interest rates will go up half a percentage point.
• The halves in the equation depend on both:
• How sensitive the economy is to interest-rate
changes, and
• The preferences of central bankers.
• The more bankers care about inflation:
• The bigger the multiplier for the inflation gap, and
• The lower the multiplier for the output gap.
18-88
A Guide to Central Bank Interest
Rates: The Taylor Rule
• The implementation of the Taylor rule requires
four inputs:
•
•
•
•
The constant term, set at 2;
A measure of inflation;
A measure of the inflation gap; and
A measure of the output gap.
• The constant is a measure of the long-term
risk-free real interest rate,
• Which is about 1 percentage point below the
economy’s growth rate.
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A Guide to Central Bank Interest
Rates: The Taylor Rule
• Economists and central bankers believe that the
personal consumption expenditure (PCE) index
is a more accurate measure of inflation than the
CPI.
• The PCE comes from the national income accounts.
• For the inflation target, we will follow Taylor
and use 2 percent.
• So the neutral target federal funds rate is 4 percent
(2 + 2).
18-90
A Guide to Central Bank Interest
Rates: The Taylor Rule
• For the output gap, the natural choice is the
percentage by which GDP deviates from a
measure of its trend, or potential.
• Figure 18.9 plots the FOMC’s actual target
federal funds rate, together with the rate
predicted by the Taylor rule.
• The two lines are reasonably close to each other.
• The FOMC changed the target federal funds rate
when the Taylor rule predicted it should.
18-91
A Guide to Central Bank Interest
Rates: The Taylor Rule
18-92
A Guide to Central Bank Interest
Rates: The Taylor Rule
We should recognize some caveats.
1. At times the target rate does deviate from the
Taylor rule, and with good reason.
•
•
It is too simple to take account of sudden threats to
financial stability.
The federal funds rate will be below the Taylor
rule in periods characterized by at least one of two
factors:
1. Unusually stringent conditions across an array
of financial markets; or
2. Deflationary worries that arose as nominal
interest rates approached their zero bound.
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A Guide to Central Bank Interest
Rates: The Taylor Rule
2. If the economy is weak and inflation is both
low and falling below the central bank’s
objective, policymakers might set their target
rate temporarily below the one implied by the
Taylor rule.
•
•
•
This is a risk management approach to policy.
We saw this in 2002-2005 when the target federal
funds rate was below that implied by the Taylor
rule.
Some economists believe that this amplified the
housing bubble and contributed to the crisis that
followed.
18-94
A Guide to Central Bank Interest
Rates: The Taylor Rule
3. There is a lack of real time data.
•
•
While we might be able to make good monetary
policy for 1995 using the Taylor rule and the data
available to us today, that isn’t of much practical
use.
Policymakers have no choice but to make good
decisions based on information that is less than
completely accurate.
18-95
• Setting monetary policy to deliver low, stable
inflation and high stable growth is never easy.
• It was particularly challenging following the
financial crisis of 2007-2009 since the Fed had no
prior experience with many of its unconventional
policy tools.
• At the time of this article, many observers
worried that the housing market and the
economy would suffer if the FOMC were to
halt buying mortgage-backed securities.
• However, the FOMC executed its plan as
scheduled.
18-96
Unconventional Policy Tools
• 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; and
2. When an impaired financial system prevents
conventional interest-rate policy from supporting
the economy.
18-97
Unconventional Policy Tools
• Let’s dismiss the belief that monetary policy
becomes ineffective when the target rate is at
zero and the financial system is impaired.
• Using unconventional policies is much more
complicated than simply changing an interestrate target.
• The exit from unconventional polices can be
difficult and destabilizing.
• Therefore, they should be used only in
extraordinary situations.
18-98
Unconventional Policy Tools
•
There are three categories of unconventional
policy approaches:
1. A policy duration commitment.
•
This is when the central bank promises to keep
interest rates low in the future.
2. Quantitative easing (QE).
•
When the central bank supplies aggregate reserves
beyond the quantity needed to lower the policy
rate to zero.
18-99
Unconventional Policy Tools
3. Credit easing (CE).
•
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.
18-100
Policy Duration Commitment
• The simplest unconventional approach is for
the central bank to make a commitment today
about future policy target rates.
• If a policy duration commitment is stated to
last for an indefinite period, we call it an
unconditional commitment.
• Alternatively, a central bank can make a
conditional commitment to keep interest rates
low until some stated economic conditions
change.
18-101
Policy Duration Commitment
• If it works, a policy commitment will lower the
long-term interest rates that affect private
spending.
• To be effective, a policy duration commitment
needs to be credible.
• Many economists advocate policy frameworks
like inflation targeting that are designed to
enhance the credibility of a duration
commitment.
18-102
Policy Duration Commitment
• Between 2002 and 2004, the FOMC issued an
unconditional commitment indicating that its
target funds rate would stay low for the
“foreseeable future” or for a “considerable
period.”
• In 2004, it assured markets that the withdrawal
of accommodation would occur at a “measured
pace” to avoid fears of sharp rate hikes.
18-103
Policy Duration Commitment
• In 2008, the FOMC adopted a conditional
approach as the financial crisis deepened.
• They announced that “weak economic conditions
are likely to warrant exceptionally low levels of the
federal funds rate for some time.”
• Although policy duration commitments can be
effective, the Fed’s experience suggests that
they are difficult to calibrate and an have
disturbing side effects.
• They, therefore, remain tools for exceptional
circumstances.
18-104
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.
• Figure 18.10 illustrates the impact of QE on
supply and demand in the federal funds market.
18-105
Quantitative Easing
• At a rate of zero, banks
hold cash rather than
lend.
• The Fed can add
limitlessly to reserves
without affecting the
market federal funds
rate.
• QE is the difference
between A and B.
18-106
Quantitative Easing
• It is difficult to predict the effects of QE.
• Our limited experience means that we have
little data on which to base such a forecast.
• Moreover, 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.
18-107
Quantitative Easing
• 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 a policy duration
commitment.
18-108
Quantitative Easing
• A problem with QE is that central banks do not
know now much is needed to be effective.
• QE can be powerful tool for central bankers to
prevent a sustained deflation, especially when
conventional policy tools have been exhausted.
• The first and only application since the Great
Depression occurred after the Lehman failure
in September 2008.
• Policymakers remain highly uncertain about the
appropriate dosage of QE and lack experience in
exiting from QE.
18-109
Credit Easing
• Credit easing (CE) shifts the composition of
the balance sheet away from risk-free assets
and toward risky assets.
• 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.
18-110
Credit Easing
• The impact of CE is likely
• To be greater in thin, illiquid markets.
• 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, CE narrows their interest rate
differences.
18-111
Credit Easing
• In buying more than $1 trillion in MBS, the
central bank’s goal was to lower mortgage
yields and support the housing market.
• A central bank cannot reliably anticipate the
impact of CE on the cost of credit.
• In normal time a central bank typically avoids
such direct allocation of credit.
• They promote competition rather than picking
winners.
18-112
Credit Easing
• CE purposely deviates from such asset
neutrality in order to influence relative prices.
• Exiting from CE probably is also more difficult
than unwinding QE.
• Risky assets are generally harder to sell than
Treasuries.
• The central bank may not 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.
18-113
Making an Effective Exit
• When central banks pursue conventional
interest-rate targets, officials think about the
policy choices they face every six to eight
weeks.
• It requires them to make moves today while
keeping in mind moves they may need to make far
into the future.
• The introduction of and exit from
unconventional policies also require looking in
to the future.
18-114
Making an Effective Exit
• Exiting from QE and CE poses additional
obstacles that appear technical but have
important implications.
• The question is whether a central bank that
wishes to raise interest rates will be able to do
so as quickly as desired.
• The answer depends on the size and
composition of the central bank’s balance sheet
and the toolset available.
18-115
Making an Effective Exit
• What happens with QE and CE 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 reserve supply sufficiently to raise
the policy rate target.
• But, QE and CE assets are typically more
difficult to sell.
18-116
Making an Effective Exit
• 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.
• However, Central banks like the Fed have
several policy options that allow them to
tighten without having to sell their assets.
18-117
Making an Effective Exit
• Central banks can raise the deposit rate that the
central bank pays on reserves.
• Remember the deposit rate sets the floor for the
market federal fund rate.
• We can see in the supply and demand for
reserves that the demand for reserves shifts,
moving the equilibrium of the reserves from A
to B.
18-118
Making an Effective Exit
18-119
Making an Effective Exit
•
Paying interest on reserves allows a central
bank to use two powerful policy tools
independently of one another:
1. It can adjust the target rate for interbank loans
without changing the size or composition of its
balance sheet, and
2. It can adjust the size and composition of its
balance sheet without changing the target interest
rate for interbank loans.
18-120
Making an Effective Exit
• This means the central bank can change its
balance sheet in a fashion consistent with
financial stability and keep inflation under
control.
• It can avoid a fire sale by simply raising the
deposit rate that they pay on reserves.
18-121
• Economic data is revised relatively often and
the revisions can be large.
• Real GDP data is:
• Initially released at the end of a quarter,
• Revised 6 times over the next 3 years, and
• Continues to be revised after that.
• When you see a headline announcing the
publication of data on recent growth in GDP,
remember that today’s figure is just a rough
estimate.
18-122
18-123
Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
End of
Chapter Eighteen
Monetary Policy: Stabilizing the
Domestic Economy
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.