Learning Objectives
Explain the conventional policy tools used by major central banks.
Discuss the links between monetary policy tools and objectives.
18-1
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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 nominal federal funds rate hit zero.
Zero lower bound: the idea that a nominal interest rate cannot fall below zero
Due to transaction costs, they can fall below zero
Effective lower bound: the nominal interest rate level below which intermediaries and their customers will switch from bank deposits to holding cash.
18-2
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Introduction
To study the financial system and the economy after the crisis, the Fed utilized its three of its conventional policy tools:
The target range for the federal funds rate
The interest rate on excess reserves (IOER rate)
The rate for discount window lending
Policymakers then proceeded to develop and use a variety of unconventional policy tools including:
Massive purchases of risky assets in fragile markets
Communicating its intent to keep interest rates low over an extended period
18-3
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18-4
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The Federal Reserve’s Conventional Policy Toolbox
The Fed has four leading conventional monetary policy tools, also known as policy instruments:
The target federal funds rate range
The interest rate on excess reserves (IOER rate)
The discount rate
The reserve requirement
The target for the Fed could change in a few years. In recent years collateralized lending has virtually replaced uncollateralized lending, which forms the basis for the federal funds rate.
18-5
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The Federal Reserve’s Conventional Policy Toolbox
18-6
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The Target Federal Fund Rate and the Interest on Excess Reserves
Prior to the financial crisis, the target federal fund rate was the FOMC’s primary policy instrument.
The federal funds rate is the rate at which banks lend reserves to each other overnight.
It is determined in the market and not controlled by the Fed.
The target federal funds rate are set by the FOMC and the market federal funds rate, at which transactions between banks take place.
18-7
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The Target Federal Fund Rate and the Interest on Excess Reserves
Discrepancies between actual and desired reserves gave rise to a market for reserves.
Some banks can lend out excess reserves.
Some banks will borrow to cover a shortfall.
Without this market, banks would need to hold substantial quantities of excess reserves as insurance against shortfalls.
Loans are unsecured.
18-8
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The Target Federal Fund Rate and the Interest on Excess Reserves
Banks demand fewer reserves as the market federal funds rate rises.
The Fed continues to be the monopoly supplier of aggregate bank reserves.
By buying or selling securities in the market through an open market operation (OMO), the Fed could increase or decrease the supply of reserves in order to lower or raise the market federal funds rate.
18-9
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The Target Federal Fund Rate and the Interest on Excess Reserves
1-10
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The Target Federal Fund Rate and the Interest on Excess Reserves
During the financial crisis, the Fed lowered its policy target close to zero, and engaged in quantitative easing making large-scale asset purchases to increase the supply of reserves far beyond the level needed to keep the federal funds rate near zero.
Policymakers began specifying a target range, instead, of a target level for the federal funds rate
Initially, the IOER rate corresponded to the upper limit of the target range, but now it is set within the target range.
1-11
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The Target Federal Fund Rate and the Interest on Excess Reserves
1-12
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The Target Federal Fund Rate and the Interest on Excess Reserves
Tightening monetary policy through the IOER rate
If there is an increase in the target range for the federal funds rate, the Fed will raise the IOER rate; raising the minimum rate at which banks are willing to lend
Allows the FOMC to raise interest rates, tightening financial conditions, without altering the supply of reserves
1-13
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The Target Federal Fund Rate and the Interest on Excess Reserves
1-14
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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
Interest rates
Today, lending by the Federal Reserve Banks to commercial banks, called discount lending, is usually small aside from crisis periods.
18-15
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Discount Lending, the Lender of Last Resort, and Crisis Management
Discount lending is the Fed’s primary tool for:
Ensuring short-term financial stability
Eliminating bank panics
Preventing the sudden collapse of institutions that are experiencing financial difficulties
The central bank is the lender of last resort:
Making loans to banks when no none else will or can.
18-16
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Discount Lending, the Lender of Last Resort, and Crisis Management
The Fed makes three types of loans:
Primary credit
Secondary credit
Seasonal credit
The Fed controls the interest rate on these loans, not the quantity of credit extended.
The banks decide how much to borrow.
18-17
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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 IOER rate called the primary discount rate.
The term discount rate usually refers to this primary discount rate
18-18
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Primary Credit
Primary credit adds to the Fed’s supply of reserves to the banks
When reserves were scarce, providing a facility through which banks could borrow at a penalty rate above the target kept the market federal funds rate from rising above the discount rate.
18-19
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Secondary Credit
Secondary credit is available to institutions that are not sufficiently sound to qualify for primary credit.
The secondary discount rate is set above the primary discount rate.
There are two reason a bank might seek secondary credit:
A temporary shortfall of reserves.
They cannot borrow from anyone else.
18-20
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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.
18-21
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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 there has been a move to eliminate seasonal credit.
They now have easy access to longer-term loans from large commercial banks.
18-22
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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.
In the U.S., the reserve requirement turns out not to be very useful.
18-23
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Operational Policy at the European Central Bank
Like the Fed’s, the ECB’s monetary policy toolbox contains:
An overnight interbank rate (equivalent to the federal funds rate)
A rate at which the central banks lends to commercial banks (equivalent to the discount rate)
A reserve deposit rate (equivalent to the IOER)
A reserve requirement
18-24
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The ECB’s Target Interest Rate and Open Market Operations
The ECB now frequently uses outright purchases of securities to inject reserves into the banking system
Prior to 2012, it provided reserves through collateralized loans in what are called refinancing operations:
The main operation was a weekly auction of repurchase agreements (repo) in which ECB, through the National Central Banks, provided reserves to banks in exchange for securities, and then reversed the transaction up to three weeks later.
When reserves were scarce, the ECB’s policy instrument was the minimum bid rate, set by the Governing Council as the minimum interest rate accepted at these refinancing auctions
Target refinancing rate
18-25
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The ECB’s Target Interest Rate and Open Market Operations
Beginning in 2007, to steady financial markets, the ECB increased the supply of reserves through longer-term refinancing operations (LTROs) at maturities ranging from one month to one year.
To stabilize bank funding in late 2011 and early 2012, the ECB extended maturities to three years.
Financial turmoil led the ECB to boost open market purchases of securities.
18-26
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The ECB’s Target Interest Rate and Open Market Operations
Differences between the ECB’s refinancing operations and the Fed’s daily open market operations:
The operations are done at all the National Central Banks (NCBs) simultaneously.
Hundreds of European banks participate in the ECB’s weekly auctions.
Because of the differences in financial structure in different countries, the collateral that is accepted in refinancing operations differs from country to country.
The ECB and the NCBs accept tens of thousands of different marketable assets as collateral, including not only government-issued bonds but also privately issued bonds and bank loans.
18-27
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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.
Commercial banks initiate these borrowing transactions when they face a reserve deficiency that they cannot satisfy more cheaply in the marketplace.
18-28
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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.
The rate paid by the deposit facility is set by the ECB Governing Council.
The deposit facility places a floor under the market interest rate charged on loans made by banks
18-29
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Reserve Requirements
The ECB requires that banks hold minimum reserves based on the level of their liabilities.
The reserve requirement of 1% is applied to deposits and debt securities with maturities up to two years.
The level of these liabilities is averaged over a month, and reserve levels must be held over the following month.
18-30
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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.
After the Lehman failure in 2008, the overnight cash rate remained within the band formed by the marginal lending rate and the deposit rate.
18-31
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Reserve Requirements
18-32
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Linking Tools to Objectives: Making Choices
Monetary policymakers’ goals are:
Low and stable inflation
High and stable growth
A stable financial system
Stable interest and exchange rates
18-33
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Linking Tools to Objectives: Making Choices
A consensus has developed among monetary policy experts that:
The reserve requirement is not useful as an operational instrument,
Central bank lending is necessary to ensure financial stability, and
Short-term interest rates are the conventional tool to use to stabilize short-term fluctuations in prices and output.
18-34
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Desirable Features of a Policy Instrument
A good monetary policy instrument has three features:
It is easily observable by everyone.
Ensures transparency in policymaking, which enhances accountability.
It is controllable and quickly changed.
An instrument that can be adjusted quickly in the face of a sudden change in economic conditions is clearly more useful
It is tightly linked to the policymakers’ objectives.
The more predictable the impact of an instrument, the easier it will be for policymakers to meet their objectives
18-35
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Desirable Features of a Policy Instrument
The reserve requirement won’t work because the effect of changes in the requirement is difficult to anticipate.
The Fed’s strategy of targeting reserves rather than interest rates from 1979-1982 was a way of driving interest rates to levels 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.
18-36
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