CHAPTER 15: MONETARY POLICY

• During the 2007-2009 crisis, the fed funds rate had a range of 0-0.25%

• The fed made huge purchases that increased the bank reserves, the monetary base, and the size of the fed's balance sheet

• The fed wanted to do the complete opposite after 2 years of the crisis to end their crisis strategy

• After 6-7 years, the fed funds rate was only 0.25%-0.50% instead of the 4% they wanted it to be

• The bank of Japan (BOJ), the bank of England (BOE), and the European central bank (ECB) all did a similar strategy

• The BOJ and ECB went further and made some interest rates below zero

• The unemployment rate was high, and the growth rate of real GDP was low

• Concerns were that recessions will be longer and deeper and recoveries will be slower

  • Low nominal interest rates resulted in unsustainably high prices of stocks and bonds

  • Low-interest rates reduced the return to savings and made it difficult to use CDs and other low-risk assets to save for retirement

  • Fed holding trillions of dollars of assets was distorting prices and yield in the financial markets, mostly the housing market

Goals of Monetary Policy

• The ultimate aim of monetary policy is to advance the economic well-being of the population

• Typically determined by the quantity and quality of goods

• Economic well-being occurs from the efficient employment of labor and capital and steady output growth, minimal fluctuations in production and employment, steady interest rates, and smoothly functioning financial markets.

• The six goals that are intended to promote economic well-being are:

  • Price stability

  • High employment

  • Economic growth

  • Stability of financial markets and institutions

  • Interest rate stability

  • Foreign exchange market stability

• Price stability: inflation erodes the value of money, inflation makes prices less useful

  • People will hesitate to enter long-term contracts since they are uncertain about how much they will be able to purchase in the future

  • Lenders suffer losses when inflation is high and retired people suffer a decline in purchasing power

  • Hyperinflation can severely damage an economy’s productive capacity

    • Money no longer functions as a store of value or a medium of exchange

    • Production plummets and unemployment soars

• High employment: congress enacted the employment act of 1946 and the full employment and balanced growth act of 1978 (Humphrey-Hawkins act) to make explicit the fed government's commitment to achieving high employment and price stability

  • Frictional unemployment: when people are job-seeking or go back to college to get another degree

  • Structural unemployment: unemployment that is caused by changes in the structure of the economy; shifts in manufacturing techniques toward automation, increased use of computers and software, age and gender composition of the workforce, changes in locations, and geographic mobility of workers.

  • Cyclical unemployment: unemployment associated with business cycle recessions

  • The natural rate of employment (aka full employment rate of unemployment): when all workers who want jobs have them and the demand and supply of labor are in equilibrium

    • The rate varies in response to changes in the age and gender composition of the labor force and changes in government policies with respect to taxes, minimum wages, and unemployment insurance compensation.

• Economic growth: increases in the economy’s output of goods and services over time

  • The only source of sustained real increase in household incomes

  • Depends on high employment

  • With high employment businesses are likely to invest in new plants and equipment to raise profits, productivity, and worker’s incomes

  • Unemployment is high then businesses have the unused productive capacity and are much less likely to invest in capital improvements

  • Want to achieve stable economic growth because a stable business environment allows firms and households to plan accurately and encourages the long-term investment that is needed to sustain growth

• Stability of financial markets and institutions: when it is not efficient in matching savers and borrowers, the economy loses resources

  • Firms will be unable to obtain the financing they need

• Interest Rate Stability: fluctuations in interest rates make planning and investment decisions difficult for households and firms

  • Make it hard for firms to plan investments in plant and equipment and make households more hesitant about long-term investments in houses

  • Fed’s goal is motivated by political pressure as well as by a desire for a stable saving and investment environment

  • Sharp interest rate fluctuations cause problems for banks and other financial firms

• Foreign exchange market stability: a stable dollar simplifies planning for commercial and financial transactions

  • Fluctuations in the dollar value change the international competitiveness of us industries

  • A rising dollar makes U.S. goods more expensive abroad and reduces exports

  • A falling dollar makes foreign goods more expensive in the U.S. and reduces imports

  • The US treasury originates changes in foreign exchange policy but the fed implements the policy changes

• The Fed's dual mandates are price stability and high employment. When the two are stable then everything else falls into place.

Monetary Policy Tools and The Federal Funds Rate

• During the 2007-2009 crisis the fed relied on three monetary policy tools:

  • Open Market Operations: purchases and sales of securities in the financial markets

  • Discount Policy: includes setting the discount rate and the terms of discount lending

    • Discount window: how the fed makes discount loans to banks, serving as the channel for meeting the liquidity needs of banks

  • Reserve Requirements: the regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the fed

• During the crisis, the fed introduced three new policy tools:

  • Interest on reserve balance (IOER or IORB): an increase in the rate will increase banks' holding of reserves, restraining their ability to extend loans and increase the money supply. The rate can help put a floor on short-term interest rates since banks will typically not lend funds elsewhere at an interest rate lower than the fed’s IOER rate. The rate is set at 3.9% since November 2, 2022 meeting

  • Overnight reverse repurchase agreement facility: to raise short-term interest rates the fed would raise the target federal funds rate and would conduct open market sales. The Fed raised its target for the FFR by raising the interest rate it pays on reserves. A reverse repo is when the Fed sells a security to a financial firm that promises to buy it back from the Fed the next day.

  • Term deposit facility: the more funds banks put in term deposits with the Fed the less they will have to expand loans and the money supply. Least important of the fed's tools

New Tools When Facing A Zero Lower Bound On The FFR

• During the crisis the fed introduced two tools to deal with zero lower bound:

  • Quantitative Easing: it’s a central bank policy that simulates the economy by buying long-term securities. Can buy treasury notes and mortgage-backed securities.

  • Forward Guidance: statements by the FOMC about how it will conduct monetary policy in the future. The statement informs firms, households, and investors that the FOMC would keep monetary policy restrictive by increasing its target rand for the federal funds rate to achieve 2 percent inflation.

The Federal Funds Market and the Feds Target FFR

• The Fed sets a target for the federal funds rate which is the interest rate that banks charge each other on very short-term loans.

• The target for the federal funds rate is set at meetings of the FOMC that occur 8 times a year.

• The Fed sets the target rate but the actual rate is set by the interaction of the demand and supply for reserves in the federal funds market.

The Traditional Assumption of Scarce Reserves

• The key assumption is that reserves are scarce

  • Many banks meet their customer’s need for reserves by borrowing from other banks in the fed funds market

  • Banks now hold large levels of reserves but during the crisis, they did not hold a lot

  • In June 2020, banks held $3.1 trillion in reserves and $3.4 trillion in checkable deposits

Demand for Reserves

• Banks demand reserves both to meet their legal obligation to hold required reserves and because they may wish to hold excess reserves to meet their short-term liquidity needs

• The demand curve is for both RR and ER

• The demand curve assumes that market interest rates or the RRR will be constant

• The higher the interest rate the lower the number of loans demanded

• As the federal funds rate iff increases the opportunity cost to banks of holding ER increases because the return they could earn from lending out those reserves goes up

• As the federal funds rate increases the number of reserves demanded will decline

• Demand because horizontal at IOER

Supply of Reserves

• The fed supplies borrowed reserves in the form of discount loans and nonborrowed reserves through open market operations

• During and after the crisis and the pandemic, the fed increased the supply of its reserves through its purchase of long-term treasury securities and mortgage-backed securities during three rounds of quantitative easing

• The discount rate is a ceiling on the federal funds rate

• At a federal funds rate below the discount rate banks will not borrow from the fed because they can borrow at a cheaper rate

Open Market Operations and the Fed’s Target FFR

• Changes in the rate can affect the economy

• When the FOMC lowers the target FFR, the rates for bank loans also decrease

• To lower the rate, the fed engaged in open market purchases

• To increase the rate, the fed engaged in open-market sales

• The fed refers to the market federal funds rate as the effective federal funds rate to distinguish that rate from the Fed target federal funds rate

The Effect of Changes In the Discount Rate and Reserve Requirements

• The fed adjusts the target for the federal funds rate through open market operations

Changes In the Discount Rate

• The fed has kept the discount rate higher than the target for the federal funds rate

• The discount rate is a penalty rate meaning that the banks pay a penalty by borrowing from the fed rather than from other banks in the federal funds market

• The fed raises and lowers the discount rate at the same time that it raises or lowers the target for the federal funds rate

• Changes in the discount rate have no independent effect on the federal funds rate

Changes In the Required Reserve Ratio

• The fed rarely changes the required reserve ratio

• Changing the RRR will cause a change in the equilibrium federal funds rate if the fed did not also engage in offsetting open market operations

• The last change took place in 1992 when the rate was reduced from 12% to 10%

• The last change took place in march 2020 to 0%

The Fed’s MP Tools and its New Approach to Managing the FFR

• Open Market Operations: The original federal reserve act of 1913 did not specifically mention open market ops

• The fed began to use open market ops as a tool during the 1920s when it acquired liberty bonds issued by the fed govt during WW1 from banks enabling banks to finance more business loans

• Before 1935, district federal reserve banks conducted limited open market operations in securities markets, but these transactions lacked central coordination and were not always used to achieve a monetary policy goal

• The lack of coordinated intervention by the fed during the banking crisis of the early 1930s led congress in 1935 to establish the FOMC to guide open market operation

• When the fed carries out an open-market purchase of treasury securities the prices of the securities increase thereby decreasing their yield

• An open market sale decreases the price of treasury securities, thereby increasing their yield

• The sale decreases the monetary base and the money supply

• Open market purchases are considered expansionary policy (loose policy)

• Open market sales are considered contractionary policy (tight policy)

Implementing Open Market Operations

• At the end of each FOMC meeting, they issue a statement that includes its target for the federal funds rate and its assessment of the economy

• The FOMC issues a policy directive to the fed res system account manager, VP of the fed res bank of NY

• Open market operations are conducted each morning in the open market trading desk at the fed res bank of NY

• The trading desk is linked electronically through a system called the trading room automated processing system to primary dealers

  • Primary dealers who are private security firms such as Goldman Sachs and Cantor Fitzgerald

  • Each morning the trading desk notifies the primary dealers of the size of the open market purchase or sale is conducted and asks them to submit offers to buy or sell treasury securities

  • Once the dealers offer has been received the feds account manager goes over the list accepts the best offer and then has the trading desk buy or sell the securities until the desired volume has been reached

• The account manager interprets the FOMC’s directive, holds a daily meeting with two members of the FOMC, and personally analyzes financial market conditions

• The account manager gives the orders to sell or purchase securities

• When reserves were scarce, the trading desk would undertake both dynamic, or permanent, open market operations and defensive, or temporary, open market operations.

• Dynamic open market operations are intended to change monetary policy as directed by the FOMC

• Defensive open market operations are intended to offset temporary fluctuations in the demand or supply for reserves not to carry out changes in monetary policy

• Federal reserve float temporarily increases the reserves of the banking system as banks that have had checks deposited see their reserves increase, while there is a delay in decreasing the reserves of banks against which checks have been written

• Dynamic open market operations are likely to be conducted as outright purchases and sales of treasury securities

• Defensive and more common than dynamic

• Defensive is done through repurchase agreements

  • The fed buys securities from a primary dealer, and the dealer agrees to buy them back at a given price at a specified future date, usually within one week

  • The securities serve as collateral for a short-term loan

• Disasters also cause unexpected fluctuations in the demand for currency and bank reserves

Open Market Operations VS Other Policy Tools

• Open market operations have several benefits that the fed’s other tools lack: control, flexibility, and speed of implementation

• The fed controls the volume of open market operations

• Discount loans depend on the bank’s willingness to request loans

• Open market ops are flexible because they can make large or small operations

  • Dynamic requires large operations

  • Defensive requires small operations

  • Open market operations can be reversed quickly but other tools can be reversed easily

• Open market ops can be implemented quickly while discount rates and reserve requirements take longer to implement

Quantitative Easing

• By December 2008, the fed had driven the target for the federal funds rate to nearly zero

• This led the fed to buy more than $1.7 trillion in mortgage-backed securities between 2009 and early 2010

• Quantitative easing: a central bank policy that attempts to stimulate the economy by buying long-term securities

• The fed’s objective was to reduce the interest rates on mortgages and 10-year treasury notes

• A lower rate on 10-year treasury notes can help lower interest rates on corporate bonds thereby increasing investment spending

• When the interest rate falls, the rates for adjustable mortgages also fall

• In November 2010, the fed took part in a second round QE2 in which it bought an additional $600 billion in long-term securities through June 2011

• In September 2011, the fed purchased $400 bill in long term and sold $400 bill in short term known as an operation twist. The fed did not increase the monetary base or cause a change in inflation

• In September 2012, the fed did the third round of QE in which it purchased mortgage-backed securities. It ended in October 2014

• In the fed’s balance sheet the fed’s assets went from $927 bill to 2.2 trill in 2008

Discount Policy

• From 1966 to before 1980, the fed would make discount loans only to banks that were members of the federal reserve system

• Banks considered the ability to borrow from the fed through the discount window as an advantage of membership that partially offset the cost of the feds reserve requirement

• Since 1980, all depository institutions had access to the discount window

• Three types of discount loans:

  • Primary credit: discount loans available to healthy banks experiencing temporary liquidity problems

    • Can use it 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 loans are short term often overnight or for some weeks

    • The rate is set above the federal funds rate so banks will typically acquire funds at a lower rate in the FF market

  • Secondary credit: discount loans available to banks that are not eligible for primary credit because they have a low supervisory rate or inadequate capital

    • Experiencing severe liquidity problems such as those that are closing

    • The fed monitors how they use the funds

    • The rate is above the primary rate by 0.50 percentage points

  • Seasonal credit: discount loans available to smaller banks in areas where agriculture or tourism is important

    • The rate is tied to the average rates on CDs and the FFR

Discount Lending During the Financial Crisis of 07-09

• The fed used its authority under section 13(3) which authorized it to lend to any individual, partnership, or corporation in unusual and exigent circumstances

• The fed concentrated on shadow banks rather than commercial banks first

• The fed set up several temporary lending facilities

  • Primary dealer credit facility: primary dealer could borrow overnight using mortgage-backed securities as collateral, and obtain emergency loans, opened in march 2008 and closed down in Feb 2010

  • Term securities lending facility: fed can loan up to $200 bill of treasury securities in exchange for mortgage-backed securities, allowing firms to borrow against illiquid assets, opened in march 2008 and closed in Feb 2010

  • Commercial paper funding facility: the fed purchased three months of commercial paper issued by nonfinancial corporations, opened in Oct 2008 and closed in Feb 2010

  • Term asset-backed securities loan facility: the fed of NY extended three-year or five-year loans to help investors fund the purchase of asset-backed securities, which are securitized consumer and business loans besides mortgages, establishes in Nov 2007 and closed in June 2010

• By mid-2010 the fed ended its facilities

• New facilities the fed established beginning in march 2020

  • Liquidity facilities: build on the fed’s original role as the lender of last resort

    • Primary deal credit facility: provides loans to 24 primary dealers with whom it interacts in the securities market to ensure their liquidity

    • Commercial paper funding facility: the fed bought commercial paper directly from corps

    • Money market mutual fund credit facility: fed used this facility to make loans to banks

    • Central bank liquidity swap lines: enable foreign central banks to exchange their currencies for dollars

    • Facility for foreign and international monetary authorities: enable these authorities to temporarily exchange their us treasury securities, held w the fed reserve, for us dollars

    • Term asset-backed securities loan facility: the fed began buying term abs backed by student loans, auto loans, credit card loans, and loans guaranteed by the SBA

  • Credit facilities: allow the fed to provide funds directly to nonfinancial firms and state and local govt

    • Primary market corporate credit facility: the fed bought newly issued bonds or syndicated loans to corporations whose bonds are related to investment grade

    • Secondary market corp credit facility: the fed bought in the secondary market investment-grade bonds issued by corps and shares in ETFs that invest in such bonds

    • Municipal liquidity facility: fed began buying short-term state and local bonds to support the ability of state, county, and city govt to borrow

    • Main street new loan facility and main street expanded loan facility: the fed offered four-year loans to companies employing up to 10,000 workers or w revenues of less than 2.5 bill to ensure businesses can survive

How the Fed Currently manages the FFR

• To fight the effects of the crisis and recession the FOMC cut the FFR from 1% to a range of 0% to 0.25%

• On Dec 16, 201,5 the fed raised the range to 0.25% and 0.50%

• The fed used two new monetary policy tools to increase the range instead of telling the NY fed to take part in open market ops

  • IOER

  • ON RRP

• Two distinct groups of financial institutions that borrow and lend in the FF market

  • Depository institutions such as commercial banks and savings and loans that deposit with the fed and earn interest

  • Financial institutions such as Fannie Mae, Freddie Mac, and the federal home loan banks are eligible to borrow and lend in the FF market and have deposits at the fed but do not earn interest

• In December 2016 there were 23 primary dealers and 61 other financial institutions that were able to participate in the reverse repurchase agreement