PROF ANNE SIBERTSPRING 2013

MONETARY POLICY IN PRACTICE

THE BALANCE SHEET OF THE FEDERAL RESERVE

ASSETS LIABILITIES

Securities Currency in circulation

Repos Depository institutions balances

Loans Reverse repos

Other assets Other liabilities

Net worth

MEASURES OF MONEY IN THE UNITED STATES

• Base money is currency in circulation, currency held in the vaults of banks and reserves held by depository institutions at the central bank. It is sometimes called high-powered money and it is called narrow money in the United Kingdom.• Base money is the amount of money produced

directly by the government.• M1 is currency in circulation, travellers’ checks

and checkable deposits.• M2 is M1 plus other accounts that can be readily

converted into M1 without significant loss of principal.

RELATIONSHIP BETWEEN CURRENCY AND M1

• Depository institutions hold cash at the Federal Reserve. This is the depository institutions balances component of the Fed’s balance sheet. They hold three types of balance.

• Required reserve balances• Contractual clearing balances• Excess reserves

REQUIRED RESERVES

• In the United States depository institutions must hold a fraction of all their transactions deposits in the form of vault cash or as reserves at a Federal Reserve bank. This fraction, the reserve requirement, is set by the Board of Governors.

• As of 2006 the reserve requirement was about ten percent on most accounts.

• The United Kingdom has no reserve requirement. The requirement in the Eurozone is one percent.

• In the United States depository institutions can use sweep accounts to avoid reserve requirements.

CONTRACTUAL CLEARING BALANCES

• Depository institutions can hold an agreed upon amount of additional balances at the Fed called contractual clearing balances. • These balances earn “interest” that can be used

to pay for the Fed services that it uses. However, if these balances fall short of the agreed upon amount then the bank must pay a penalty fee.

EXCESS RESERVES AND INTEREST ON RESERVES

• If a bank is uncertain about its cash needs it can hold additional buffer reserves at the Federal Reserves called excess reserves.• The Federal Reserve Banks pay interest on

required reserve balances. This is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions. • Since 1 Oct 2008 the Fed pays interest on excess

balances. This rate is also determined by the Board and gives the Federal Reserve an additional tool for the conduct of monetary policy.

THE MONETARY BASE AND THE MONEY SUPPLY

• Suppose that banks hold a fraction R of their deposits as reserves and lend out the rest. • Suppose that the central bank increases the

money supply by 100 million currency units.• The market participants take the 100 million units

to the bank (call this Bank A) and deposit them. The bank lends keeps a fraction R as reserves and lends out a fraction R.

BANK A

What happens next

• When Bank A loans out 100 x ( 1 – R) units, the borrowers deposit this amount into Bank B. Bank B holds a fraction R as reserves and lends out a fraction 1 - R

Change in Bank A’s Balance Sheet

Change in Assets

Change in Liabilities

Reserves + 100 x R million

Deposits + 100 million

Loans + 100 x (1 – R) million

BANK B

What happens next

• When Bank B loans out 100 x ( 1 – R)2 units, the borrowers deposit this amount into Bank C. Bank C holds a fraction R as reserves and lends out a fraction 1 – R.

Change in Bank B’s Balance Sheet

Change in Assets

Change in Liabilities

Reserves + 100 x R(1 – R) million

Deposits + 100 x (1 – R) million

Loans + 100 x (1 – R)2 million

CHANGE IN THE MONEY SUPPLY

• The change in the money supply is then the original increase 100 million deposited at Bank A, the 100 x (1 – R) million deposited at Bank B, the (1 – R)2 million deposited at Bank C and so on.

• Thus, the total increase is 100 x [ 1 + (1 – R) + (1 – R)2 + … ].

• If |x|< 1, then 1 + x + x2 … = 1/(1 – x). Thus, 1 + (1 – R) + (1 – R)2 + … = 1/[1 – (1 – R)] = 1/R.

• If banks hold 10 percent of their deposits as reserves, then a 100 million unit increase in currency increases the money supply by 1000 million units.

• If banks hold 20 percent of their deposits as reserves, then a 100 million unit increase in currency increases the money supply by 500 million units.

THE MONEY MULTIPLIER

• The total increase in the money supply brought about by the central bank’s increase in the money supply through open market operations depends on the amount of reserves that banks want to hold. Note that R depends on economic conditions and varies over time.• The increase in the money supply brought about

by a one unit increase in base money is called the money multiplier.

FEDERAL FUNDS MARKET

• The federal funds market is a US interbank market for immediately available funds. Loans are uncollateralised and are usually for overnight.• The participants who borrow in the market are

depository institutions that need to meet reserve requirements.• The Federal Reserve can affect the supply in the

market with open-market operations: changing the amount of securities and repos that it holds.• It can also affect supply by lending at its discount

window.

DISCOUNT WINDOW

• The discount window is the mechanism whereby banks receive short-term collateralised loans from the central bank.

• In the United States discount window borrowing is viewed as lender of last resort borrowing and there is a penalty interest rate.

• In the United States the rates are set by the Federal Reserve Banks with the approval of the Board of Governors.

• If the discount rate is below the federal funds rate then borrowing is increasing in the spread between the federal funds rate and the discount window.

• In non-crisis times the Fed discourages repeated borrowing at the discount window.

• Since January 2003 the discount rate has been above the fed funds rate to discourage borrowing.

OPEN MARKET OPERATIONS

• The Fed conducts two types of open market operations: outright transactions and repurchase or reverse repurchase transactions.

• In an outright transaction the trading desk buys or sells a security to a dealer. In normal times this security is a previously issued government security.

• In a repurchase transaction the trading desk buys securities from a dealer and the dealer agrees to buy them back at an agreed upon later date. This is equivalent to a collateralised loan. There are also reverse repurchase transactions where the trading desk sells securities and agrees to buy them back.

OPEN MARKET OPERATIONS

• When the Fed buys securities from a dealer it pays for the security by crediting the reserve account of the dealer’s bank at a Federal Reserve Bank. [Recall: an increase in a liability is a credit.]• The Fed’s assets increase and depository

institutions’ reserves increase.• When the Fed sells securities to a dealer it is paid

by debiting the reserve account of the dealer’s bank at a Federal Reserve.• The Fed’s assets decrease and depository

institutions’ decrease.

THE SUPPLY OF RESERVES

• The supply of reserves comes through two channels:• Open-market

operations (non-borrowed reserves)

• Borrowing at the discount window

• This is upward sloping if the discount rate is below the fed funds rate and vertical otherwise

• The supply of reserves

Federal funds rate

THE DEMAND FOR RESERVES

• The demand for excess reserves is decreasing in the spread between the federal funds rate and the interest rate paid on excess reserves (this is the opportunity cost of holding reserves)

• The fed funds market

Federal funds rate

D

S

TARGETING THE FED FUNDS RATE

• The Federal Open Market Committee of the Federal Reserve System makes monetary policy by choosing a target federal funds rate.• The choice of a target rate will imply a level of

total reserves.• If the money multiplier is relatively stable then

this will provide a link between reserves and M1 and hence a link between the interest rate and M1.

WHY TARGET AN INTEREST RATE?

• Suppose a central bank is charged with meeting an inflation target or is just supposed to have a good inflation performance.

• Suppose inflation is too high or too variable. Is the central bank unlucky, or opportunistic or incompetent?

• The public might attempt to infer what is going on from open-market operations, reserve requirements and discount window rates whether or not the central bank is being too expansionary, but the relationship between these instruments and inflation is complex.

• The relationships are difficult for the central bank to infer as well and because of this difficulty in knowing what level of a particular instrument will be most apt to produce a given inflation rate, central banks often use intermediate targets.

WHY NOT TARGET THE MONEY SUPPLY

• As many economists believed that there is a stable long-run relationship between money and inflation, monetary aggregates were a popular intermediate target in the 1970s and 1980s and were used by the German Bundesbank and the Swiss National Bank.

• A problem with this regime is that its merits depend upon the short-term and medium-term relationships between the monetary aggregates chosen as targets and inflation. Currently, these relationships are not stable or predictable enough for monetary aggregates targeting to be a good way of ensuring that inflation is low and not too variable.

• In addition, the targeting of monetary aggregates is relatively hard for the public to understand, making it more difficult to acquire and maintain a reputation for inflationary toughness.

• The success of the Bundesbank in maintaining low inflation may have been due to its legendary inflation aversion, rather than its money targetting.

THE ECB AND M3

• The ECB originally assigned a prominent role to the broad monetary aggregate M3, stating that it would announce a reference value for M3 that would be consistent with price stability. While the Governing Council of the ECB did not commit to always meeting this target in the short run, it stated that deviations would signal a threat to its low-inflation objective.

• This policy was probably intended as a mechanism for the ECB to communicate its monetary policy to the public. However, as M3 regularly exceeded its reference value the policy served only to undermine the ECB’s credibility.

• On 8 May 2003, to the near universal approval of academic economists, the Council announced that M3 no longer had a special role.

MONETARY AGGREGATES

• While it is neither surprising nor regrettable that the targeting of monetary aggregates has been abandoned, it may seem somewhat curious that money is of so little importance in modern monetary policy making.

• There is a well established connection between monetary base creation by central banks and the rate of inflation in the long run. Mervyn King (2002) calculates that over the 30-year horizon 1968-1998 the correlation coefficient between both narrow and broad measures of money and inflation was .99.

• Yet, money plays no role in the canonical New Keynesian macroeconomic model that is in vogue today. Econometric forecasting models in most central banks do not include money.

• The problem is that, as previously mentioned, the short-run correlation between money and output is small and unstable so that reduced-form models are of little use.

• Not all economists have despaired of developing structural models that would enable the extraction of information from monetary aggregates, but this research is in its infancy.

INTEREST RATES AS INTERMEDIATE TARGETS

• As a result of the problems with monetary aggregates, most inflation-targeting central banks have adopted short-term interest rates as intermediate targets.

• Monetary policy makers make monetary policy by announcing a policy interest rate and then having the central bank staff conduct liquidity management operations to attempt to ensure that the announced policy rate coincides with some reference interest rate.

• Thus, central bank short-term interest rates often play a double role in central bank policy: they serve as intermediate targets and they are used to signal the central bank’s monetary policy stance to the public.

• For many central banks the policy rate and the reference rate coincide. The ECB does not have a formal reference rate, although the EONIA rate, a benchmark unsecured overnight rate may be an informal reference rate. The ECB’s policy rate is the minimum bid rate on its main refinancing operations. Unusually, the Swiss National Bank uses the three-month uncollateralised interbank interest rate as both its policy rate and its reference rate. 

FEDERAL FUNDS TARGETTING

• Since 1988 the Federal Open Market Committee of the Federal Reserve has primarily made monetary policy by selecting a policy interest rate: the target federal funds rate.• The Federal Reserve Bank of New York, acting as

agent for the FOMC, conducts open-market operations to attain this targeted rate.• Beginning in 1994, the FOMC began announcing

changes in its policy stance.• In1995 the Fed began to explicitly state its target

level for the federal funds rate

ATTAINING THE TARGET RATE

• In usual times the Fed attains its target by offsetting transitory changes in depository institutions’ reserves.

• If it wants to increase these reserves it engages in repurchase agreements (“repos”). These operations are equivalent to short-term collateralised loans but technically they are arrangements where the Fed buys securities in exchange for reserves and agrees to subsequently resell them.

• The Fed’s terminology is unusual. A repo is an agreement to sell securities and then to buy them back at a later date. The Fed is viewing things from its counterparty’s point of view.

• As a result, the Fed’s balance sheet temporarily expands: the monetary base component of its liabilities rises, as does the repo component of its assets

ATTAINING THE TARGET RATE

• If the Fed wants to decrease depository institutions’ reserves it engages in reverse repos. These are similar to short-term collateralised borrowing but technically they are arrangement where the Fed sells assets in exchange for reserves and agrees to subsequently repurchase them.

• Reverse repos change the composition of the Fed’s liabilities: the monetary base component falls and the reverse repo component rises.

•  To offset more permanent factors that would keep the federal funds rate from its target, the Fed must make a more permanent change in its balance sheet. To permanently increase liquidity the Fed expands its balance sheet: purchasing securities and increasing the monetary base. To decrease liquidity it contracts its balance sheet: selling securities and decreasing the monetary base.

MONETARY POLICY IN THE CRISIS

• Unfortunately for the FOMC, as well as other monetary policy committees around the world, by the time the global financial crisis started in earnest in September 2008, policy interest rates were already quite low and there was little scope to reduce them further. • After the onset of the credit crisis in August 2007

the FOMC had cut its policy interest rate sharply. As seen in Figure 2 below, the federal funds target rate was 2.0 percent in September 2008; by December of that year it had been reduced to the range 0 - .25 percent.

Source: Board of Governors of the Federal Reserve System

QUANTITATIVE EASING

• Another idea: Instead of announcing a policy interest rate, the central bank could simply engage in further expansionary open-market operations, selling home-currency denominated securities to increase the monetary base.

• This idea, referred to then as quantitative easing, was tried in Japan in 2000. •  Unfortunately, quantitative easing did not work well there and theory

suggests that simply increasing the monetary base is not effective when interest rates are near zero.

• In such a scenario the private sector is already holding as much money as it wants for transaction purposes and it perceives money and low-interest-bearing government securities as good substitutes. It is in a liquidity trap.

• An increase in the monetary base accompanied by an equal-sized increase in central bank holdings of low-interest-bearing government securities, therefore produces little change in the behaviour of households and firms and hence, little change in nominal variables.

• With little change in nominal variables, even unanticipated monetary policy cannot produce much change in real variables. Conventional open-market operations are of little effect in a low-interest-rate environment.

CRISIS MONETARY POLICY

• In an attempt to free up illiquid markets and deal with failed financial institutions, central banks began to explore more unusual types of monetary policy. • In the United States, the Federal Reserve bought

the debt of Fannie Mae, Freddie Mac and the Federal Home Loan banks, as well as mortgage-backed obligations guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. It also engaged in other crisis-related activities such as the creation of the Maiden Lanes I, II and III vehicles.

BALANCE SHEET OF THE FED

In 1000 millions of dollars, source: Federal Reserve Board

QUANTITATIVE EASING

• The change in the Federal Reserve’s Balance Sheet between the end of 2007 and the end of 2008 was the result of a combination of garden-variety quantitative easing that increased the size of the Federal Reserve’s assets by about 250 percent and a change in the composition of its assets that increased their riskiness and reduced their liquidity. • Such a change in the composition is referred to

as qualitative easing, credit easing or – at the ECB – enhanced credit support.

Source: Federal Reserve

OPERATION TWIST

• If long rates could be lowered, this would boost demand directly, and also indirectly, by boosting the value of long-dated real assets such as equity, land and real estate and weakening the exchange rate.

• Desperate for further ideas, on Mar 2009 the Federal Reserve announced a programme under which it purchased $300 billion of Treasury securities by Oct 2009. These included securities across the maturity spectrum, but most were of intermediate maturity.

• The idea of the Fed swapping debt of different maturities to change the yield curve is not new: it was tried briefly, with little obvious success, in the 1960s and was called Operation Twist.

• Unfortunately, as long as markets are efficient, economic theory predicts that such a move should have no impact.

• The government has a monopoly on issuing money; hence, its price depends on its supply. But, any household, firm or institution can issue debt and any debt held is one party’s asset and another’s liability. Its net supply is always zero in equilibrium and its price does not depend on the amount issued by any particular party.

EFFECTIVENESS

• None of the Federal Reserve’s actions since the crisis began have yet had an obvious direct stimulative effect on the economy, although the qualitative easing has helped indirectly by increasing liquidity and assisting in the restructuring of the banking system. • The massive increase in the Federal Reserve

System’s balance sheet featured an increase in the monetary base, but most of this was due to an increase in banks’ excess reserves. Banks are holding most of the increase in the money supply as deposits at the Federal Reserve.

M1 AND M2

INFLATION