Lecture 10

Monetary Policy
Inflation in the US rose at fastest
pace in 40 years in March as
consumer prices jumped 8.5%.
What do you think may cause this
high inflation? Can the Fed stamp
out US inflation without causing a
recession?

2
Content

• Introduction • Linkages between tools,

• The Federal Reserve’s policy instruments,
conventional policy toolbox intermediate targets, and
• The Fed funds rate goals
• Tools of the Fed and the Fed • Monetary targeting in
funds rate different countries
• The Federal funds rate and the • Inflation targeting
market for reserves
• Inflation targeting in
• Open market operations
different countries
• Discount policy
• Reserve requirements
• Unconventional policy
tools
• Monetary policy tools of the
European Central Bank • Quantitative easing
• Desirable features of a policy • Credit easing
instrument • Making an effective exit
18-3
Readings

• Mishkin (2021), The Economics of

Money, Banking, and Financial
Markets, 13th edition, Pearson,
Chapters 16 + 17
• Cecchetti and Schoenholtz (2010),
Money, Banking, and Financial
Markets, 3rd edition, McGraw-Hill,
Chapter 18

4
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.

5
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. 6
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.

7
8
Introduction

• To steady the financial system and the

economy after the crisis, the Fed utilized
its principal conventional policy tools:
– The federal funds rate target,
– The rate for discount window lending,
– The required reserve rate, and
– The deposit rate.
• They did so to the fullest extent possible
to support economic activity.

9
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.
10
Introduction
• In these lectures 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.
11
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.
12
The Federal Reserve’s
Conventional Policy Toolbox
• The Fed has four conventional
monetary policy tools, also known
as monetary policy instruments:
1. The target federal funds rate,
2. The discount rate,
3. The deposit rate, and
4. The reserve requirement.
• Each of these tools are related to
several of the central bank’s
functions and objectives. 13
The Federal Reserve’s Conventional
Policy Toolbox

14
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. 15
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
16
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. 17
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
The Target Federal Fund Rate
and Open Market Operations

19
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. 20
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.

21
The Market For Reserves and
the Federal Funds Rate
• Demand and Supply in the Market for
Reserves
• What happens to the quantity of reserves
demanded by banks, holding everything else
constant, as the federal funds rate changes?
• Excess reserves are insurance against deposit
outflows
– The cost of holding these is the interest
rate that could have been earned minus
the interest rate that is paid on these
reserves, ier
22
Demand in the Market for Reserves

• Since the fall of 2008 the Fed has paid

interest on reserves at a level that is set at
a fixed amount below the federal funds
rate target.
• When the federal funds rate is above the
rate paid on excess reserves, ier, as the
federal funds rate decreases, the
opportunity cost of holding excess
reserves falls and the quantity of reserves
demanded rises
• Downward sloping demand curve that 23
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.
24
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. 25
Supply in the Market for Reserves

• Two components: non-borrowed and borrowed

reserves
• Cost of borrowing from the Fed is the discount rate
• Borrowing from the Fed is a substitute for borrowing
from other banks
• If iff < id, then banks will not borrow from the Fed and
borrowed reserves are zero
• The supply curve will be vertical
• As iff rises above id, banks will borrow more and more
at id, and re-lend at iff
• The supply curve is horizontal (perfectly elastic) at id
26
Figure 1 Equilibrium in
the Market for Reserves

18-27
How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate

• Effects of open an market operation

depends on whether the supply curve
initially intersects the demand curve in
its downward sloped section versus its
flat section.
• An open market purchase causes the
federal funds rate to fall whereas an
open market sale causes the federal
funds rate to rise (when intersection
occurs at the downward sloped section).
28
How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate

• Open market operations have no

effect on the federal funds rate when
intersection occurs at the flat section
of the demand curve.

29
How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate
• If the intersection of supply and demand
occurs on the vertical section of the supply
curve, a change in the discount rate will
have no effect on the federal funds rate.
• If the intersection of supply and demand
occurs on the horizontal section of the
supply curve, a change in the discount
rate shifts that portion of the supply curve
and the federal funds rate may either rise
or fall depending on the change in the
discount rate
30
How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate

• When the Fed raises reserve

requirement, the federal funds rate
rises and when the Fed decreases
reserve requirement, the federal
funds rate falls.

31
Figure 2 Response to an Open
Market Operation

32
Figure 3 Response to a Change
in the Discount Rate

33
Figure 4 Response to a Change in
Required Reserves

34
Figure 5 Response to a Change in the
Interest Rate on Reserves

35
Figure 6 How the Federal Reserve’s
Operating Procedures Limit Fluctuations
in the Federal Funds Rate

36
Conventional Monetary Policy Tools

• During normal times, the Federal Reserve

uses three tools of monetary policy—open
market operations, discount lending, and
reserve requirements—to control the
money supply and interest rates, and
these are referred to as conventional
monetary policy tools.

37
Open Market Operations

• Dynamic open market operations

• Defensive open market operations
• Primary dealers
• TRAPS (Trading Room Automated
Processing System)
• Repurchase agreements
• Matched sale-purchase agreements

38
The Target Federal Fund Rate and
Open Market Operations

39
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.
40
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.

18-41
Advantages of Open Market Operations

• The Fed is in complete control of the

tool. Discount rate tool needs
cooperation of the banks.
• OMO is flexible and precise; it can be
small or large.
• OMO can be reversed easily.
• OMO is fast. There is no time lag
between the evaluation and the
impact.
42
• 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.
43
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.
44
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. 45
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.

18-46
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.

47
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.

48
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.

49
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.
50
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.

51
Reserve Requirements

• Reserve requirements 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.
52
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.
53
Disadvantages of Reserve Requirements

• No longer binding for most banks

• Can cause liquidity problems
• Increases uncertainty for banks

54
• 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.
55
• 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 56
57
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.

58
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.

59
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.

60
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.

61
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.
62
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.
63
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.

64
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 65
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.

66
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.
67
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.
68
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.
69
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.
70
Reserve Requirements

18-71
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.
72
Linking Tools to Objectives:
Making Choices

• Operating instruments refer to actual tools of

policy. These are instruments that the central
bank controls directly
• Central bankers have largely abandoned
intermediate targets
• Policymakers instead focus on how their actions
directly affect their target objectives
73
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.

74
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.

75
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.
76
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?
77
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.
78
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. 79
Desirable Features of
a Policy Instrument
Money targeting
Japan
• In 1978 the Bank of Japan began to
announce “forecasts” for M2 + CDs
• Bank of Japan’s monetary performance was
much better than the Fed’s during 1978-
1987
• In 1989 the Bank of Japan switched to a
tighter monetary policy and was partially
blamed for the “lost decade”
•
80
Desirable Features of
a Policy Instrument
Money targeting
Germany
• The Bundesbank focused on “central bank
money” in the early 1970s
• A monetary targeting regime can restrain
inflation in the longer run, even when targets
are missed
• The reason of the relative success despite
missing targets relies on clearly stated
monetary policy objectives and central bank
engagement in communication with the public

81
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 82
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. 83
• 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. 84
Inflation targeting

• New Zealand (effective in 1990)

• Inflation was brought down and remained within
the target most of the time
• Growth has generally been high and
unemployment has come down significantly
• Canada (1991)
• Inflation decreased since then, some costs in term
of unemployment
• United Kingdom (1992)
• Inflation has been close to its target
• Growth has been strong and unemployment has
been decreasing 85
Inflation targeting

Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin,

and Adam S. Posen, Inflation Targeting: Lessons from the
International Experience (Princeton: Princeton University Press,
1999), updates from the same sources, and
www.rbnz.govt.nz/statistics/econind/a3/ha3.xls

86
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.
87
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
interest-rate target.
• The exit from unconventional polices can be
difficult and destabilizing.
– Therefore, they should be used only in
extraordinary situations.

88
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.
89
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.

90
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.
91
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.

92
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.
93
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.
94
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.
95
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.

96
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.
97
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.
98
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. 99
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.

100
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.
101
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.
102
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.

103
Some unconventional monetary policy
tools of the Fed
Policy Tool Description
The Fed auctions a fixed volume of funds at
Term Auction Facility (TAF) maturities less than three months against
collateral to depository institutions
The Fed lends overnight to primary dealers
Primary Dealer Credit
(including nonbanks) against a broad range of
Facility (PDCF)
collateral
The Fed provides Treasury securities in exchange
Term Securities Lending
for a broad range of collateral in order to promote
Facility (TSLF)
market liquidity
Asset-backed Commercial The Fed lends to depositories and bank holding
Paper (ABCP) Money Market companies to finance purchases of ABCP from
Mutual Fund (MMMF) MMMFs
Liquidity Facility
The Federal Reserve Bank (FRB) of New York
Commercial Paper Funding
finances the purchase of commercial paper from
Facility (CPFF)
eligible issuers via primary dealers
Money Market Investor The FRB New York funds investment vehicles that
Funding Facility (MMIFF) purchase assets from MMFFs
Term Asset-Backed The FRB New York lends to holders of high-rated
Securities Loan Facility newly issued asset-backed securities (ABS), using
(TALF) the ABS as collateral
104
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.
105
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.

106
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.
107
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.
108
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. 109
Making an Effective Exit

110
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 111
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.

112
113
114
115
116
Practical exercise
(to be completed in your own time)

• Many countries have central banks that

are responsible for their nation’s
monetary policy. Go to
www.bis.org/cbanks.htm and select one
of the central banks (for example,
Vietnam). Review that bank s website to
determine its policies regarding
application of monetary policy. How
does this bank’s policies compare to
those of the Fed?
117
Other readings
• Bernanke, “Deflation: Making Sure ‘It’ Doesn’t
Happen Here”:
http://www.federalreserve.gov/boarddocs/speec
hes/2002/20021121/default.htm
• Kohn, “Monetary Policy and Asset Prices
Revisited”:
http://www.federalreserve.gov/newsevents/spee
ch/kohn20081119a.htm
• Santomero, “What Monetary Policy Can and
Cannot Do”:
http://www.phil.frb.org/research-and-data/public
ations/business-review/2002/q1/brq102as.pdf
• The Economist, “Level Worship”:
http://www.economist.com/node/17359344 118
Other readings
• Thornton, “How Did We Get to Inflation Targeting and
Where Do We Need to Go to Now? A Perspective
from the U.S. Experience”,
http://research.stlouisfed.org/publications/review/12/
01/65-82Thornton.pdf

• Friedman, “Why the Federal Reserve Should Not

Adopt Inflation Targeting”,
http://www.economics.harvard.edu/files/faculty/20_W
hy%20the%20Federal%20Reserve%20Should%20No
t%20Adopt%20Inflation%20Targeting.pdf
• Smagi, “Conventional and unconventional monetary
policy”,
http://www.ecb.int/press/key/date/2009/html/sp0904
28.en.html
119