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Chapter 18 – Monetary Policy: Stabilizing the Domestic Economy

Chapter 18

Monetary Policy:

Stabilizing the Domestic Economy

Chapter Overview

The purpose of this chapter is to study three different links: the link from the central

bank’s balance sheet to its policy tools; the link from the policy tools to the policymakers’

objectives; and the link from monetary policy to the real economy. We’ll begin with the

operational details that define the tools central bankers have at their disposal. Then we’ll

turn to a discussion of the relationship between those tools and the policymakers’

objectives, to explain why modern monetary policy is equivalent to interest rate policy.

Finally, we’ll look at how the level of the target interest rate is chosen. To keep the

discussion manageable, we’ll focus on monetary policy in large economies like the

United States and the Euro area. In the next chapter, we’ll discuss exchange rates and

issues that are important to central banks in small, open economies.

Learning Objectives: Establish an understanding of:

1. Fed and ECB conventional policy tools

2. How policy tools link to objectives

3. Simple guides for policy setting

4. Unconventional policy tools

Important Points of the Chapter

Central bankers have a long list of goals and a short list of tools they can use to achieve

them. They are supposed to stabilize prices, output, the financial system, exchange rates,

and interest rates, yet the only real power they have comes from their control over their

own balance sheet and their monopoly on the supply of currency and reserves. To

achieve their goals, policymakers can change the size of the monetary base by buying and

selling assets – primarily government securities – and by making loans to banks. But as

we saw at the end of the last chapter, modern central bankers cannot use these tools to

control the quantity of money. Instead, they use them to control interest rates – both the

market rate for reserves and the rate they charge for discount loans. These are the

primary tools of monetary policy. Indeed, modern monetary policy is equivalent to

interest rate policy.

Application of Core Principles

Principle #4: Markets. If the Fed wanted to, it could force the market federal funds rate

to equal the target rate all the time by participating directly in the market for overnight

reserves, both as a borrower and as a lender. The Fed has never done this because it does

not want the credit risk that would come with uncollateralized lending and because

policymakers believe that the federal funds market provides valuable information about

the health of specific banks.

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Chapter 18 – Monetary Policy: Stabilizing the Domestic Economy

Principle #5: Stability. Comparing the FOMC’s target federal funds rate with the market

rate over the last few years shows that the two were close on most days, but every so

often the system seemed to go haywire, creating occasional spikes in the market interest

rate. As information systems have improved, both within banks and at the Fed, there

have been fewer of these surprises.

Principle #5: Stability. Discount lending today is not an important part of day-to-day

monetary policy but is the Fed’s primary tool for ensuring short-term financial stability,

for eliminating bank panics, and preventing the sudden collapse of institutions that are

experiencing financial difficulties.

Principle #4: Markets. The European system is designed to give the ECB tight control

over the short-term money market in the euro area, and it works. Compared to the United

States’ federal funds rate, the European system is clearly more successful in keeping the

short-term interest rate close to target.

Principle #5: Stability. Over the years a consensus has developed among monetary

policy experts that the reserve requirement is not useful as an operational instrument, that

central bank lending is necessary to ensure financial stability, and that short-term interest

rates are the tool to use to stabilize short-term fluctuations in prices and output.

Teaching Tips/Student Stumbling Blocks

It may be interesting to start this topic by putting the federal funds rate in context.

Visit the web site of the Federal Reserve Bank of New York and you’ll find a

history of the federal funds rate, the discount rate, and the changes that have been

made going back to the early 1970s. The site is:

http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

Features in this Chapter

Your Financial World: What the Federal Funds Rate Means to You

Changes in the federal funds rate affect other interest rates, and the effect for consumers

can be dramatic. As illustrated in this section, an increase in the interest rate on a 30-year

mortgage can cost the consumer a significant additional amount in the monthly payment.

Applying the Concept: The Channel System and Future of Monetary Policy

Modern policymakers use the central bank’s monopoly over the monetary base to price

reserves in overnight markets (that’s the federal funds rate in the United States). But

numerous innovations are reducing the demand for the monetary base which raises

questions about the future of monetary policy. In Australia, Canada, and New Zealand,

central bankers have eliminated reserve requirements entirely, but conduct monetary

policy using a “channel” or “corridor” system that involves setting a target interest rate

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Chapter 18 – Monetary Policy: Stabilizing the Domestic Economy

and a lending and deposit rate which serve as bounds on the movement of the overnight

interest rate. Even as reserve demand goes to zero, this system will still give monetary

policymakers a tool to influence the economy.

Tools of the Trade: Some Unconventional Policy Tools

To stabilize the financial system and the economy during the crisis of 2007-2009, the Fed

undertook a range of unprecedented policy actions. The target federal funds rate dropped

to zero nominally and the Fed balance sheet ballooned. Fed authorities purchased a large

volume of risky assets and cut the holdings of short-term Treasuries. The Fed employed

a wide variety of new policy tools, some of which have expired now and several of which

involved lending to nonbanks.

Applying the Concept: Inflation Targeting

During the 1990s a number of countries adopted a policy framework called inflation

targeting in an effort to improve monetary policy performance, and it seems to have

worked. Inflation targeting bypasses intermediate targets and focuses directly on the

objective of low inflation. It is a monetary policy strategy that involves the public

announcement of a numerical inflation target, together with a commitment to make price

stability the central bank’s primary objective. This approach creates an environment in

which everyone believes policymakers will keep inflation low, so that long-term

expectations of inflation remain low, anchoring long-term interest rates and promoting

growth. Central banks that employ inflation targeting operate under a hierarchical

mandate, in which inflation comes first and everything else comes second. This strategy

increases policymakers’ accountability and helps to establish their credibility.

In the News: How Jawboning Works

Recently, the Federal Reserve has been able to influence the economy through their

words. Several examples of statements made by the Fed and the ECB show just how

powerful these statements can be.

Lessons of the Article: Communication is a powerful tool of a credible central bank.

Forward guidance about monetary policy influences market prices and economic behavior

today. Similarly, a central bank that pledges to act as lender of last resort can halt a run on

a bank or a sovereign debtor. However, any promise about policy may get tested, so a

central bank must follow through if it is to remain credible and effective.

Your Financial World: Economic History is Constantly Changing

Economic data are published and then revised numerous times, and the revisions can be

significant. So our view of what really happened in the economy must be adjusted

regularly. This makes the job of real-world policymaking even harder than it already is,

since officials have no choice but to make decisions based on information that is less

accurate than anyone would like.

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Additional Teaching Tools

In a March 5, 2010, article in the Wall Street Journal entitled “Fed’s Rosengren: Current

Policy Is ‘Appropriate,’” Michael Derby reports that Federal reserve bank of Boston

President Eric Rosengren says that a slow recovery and no signs of emerging inflation

threats mean the Federal Reserve can hold off for some time before tightening monetary

policy. The article can be found at

http://blogs.wsj.com/economics/2010/05/05/feds-rosengren-current-policy-is-appropriate/

?KEYWORDS=monetary+policy+tools.

Virtual Tools

Learn more about open market operations on this site from the New York Federal

Reserve Bank:

http://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html

Read the most recent statement issued by the FOMC on its web site at:

http://www.federalreserve.gov/newsevents/default.htm . Click “FOMC Statement.”

Visit the European Central Bank on the web at:

http://www.ecb.int/home/html/index.en.html

Learn more about the Taylor Rule at this site from the St. Louis Fed:

http://research.stlouisfed.org/conferences/homer/rule.html

Many people wonder what happens to the Fed after Greenspan. Is the Taylor Rule the

answer? Read this article and decide.

http://www.cnn.com/ALLPOLITICS/time/2001/02/26/taylor.html

John Taylor’s personal page (including a picture) can be found at:

http://www.stanford.edu/~johntayl/

For More Discussion

How important is it that the Fed not surprise financial markets? Discuss the themes in the

articles cited above and relate them to the criterion of transparency discussed in the text.

Chapter Outline

I. The Federal Reserve’s Monetary Policy Toolbox

A. Like all central banks, the Fed can control the quantity of reserves that

commercial banks hold.

B. Besides the quantity of reserves, the central bank can control either the size of

the monetary base or the price of its components.

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C. The three prices it concentrates on are the interest rate at which banks borrow

and lend reserves overnight (the federal funds rate) and the interest rate at

which banks can borrow reserves from the Fed (the discount rate), and the

interest rate that the Fed pays on excess reserves that banks hold at the central

bank (the deposit rate).

D. The Fed has four conventional monetary policy tools, or instruments: the

target federal funds rate, the discount rate, the deposit rate, and the reserve

requirement.

E. During the crisis of 2007-2009, the Fed developed and used a variety of

unconventional policy tools including commitments to keep interest rates low

and massive purchases of risky assets.

F. The Target Federal Funds Rate and Open Market Operations

1. The target federal funds rate is the FOMC’s primary policy instrument.

FOMC meetings always end with a decision on the target level, and the

statement that is released after the meeting begins with an announcement

of that decision.

2. The federal funds rate is determined in the market, rather than being

controlled by the Fed.

3. The name “federal funds” comes from the fact that the funds traded by

banks are their deposit balances at the Fed.

4. If the Fed wanted to, it could force the market federal funds rate to equal

the target rate all the time by participating directly in the market for

overnight reserves, both as a borrower and as a lender.

5. Policymakers believe that the federal funds market provides valuable

information about the health of specific banks.

6. The Fed allows the federal funds rate to fluctuate around the target in a

corridor defined by the discount rate and the deposit rate.

7. The Fed chooses to control the federal funds rate by manipulating the

quantity of reserves through open market operations: the Fed buys or sells

securities to add or drain reserves as required.

8. Day-to-day control of the supply of federal funds is the job of the Open

Market Trading Desk at the New York Federal Reserve Bank.

9. Most days the market rate is close to the target rate, although on occasion

there have been spikes in the market rate.

10. Changes in the reserve accounting rules in 1998, combined with

improvements in information systems both within banks and at the Fed

made it easier for the Open market Trading Desk to estimate reserve

demand. The use of the discount rate as a daily cap on the funds rate after

2002 seems to have stabilized the market.

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G. Discount Lending, the Lender of Last Resort and Crisis Management

1. Lending to commercial banks is usually small except in crisis periods.

2. However, such lending is the Fed’s primary tool for ensuring short-term

financial stability, for eliminating bank panics, and preventing the sudden

collapse of institutions that are experiencing financial difficulties.

3. The central bank is the lender of last resort, making loans to banks when

no one else can or will, but a bank must show that it is sound to get a loan

in a crisis.

4. The current discount lending procedures also help the Fed meet its

interest-rate stability objective.

5. The Fed makes three types of loans: primary credit, secondary credit, and

seasonal credit.

6. Primary credit is extended on a very short-term basis, usually overnight, to

sound institutions. It is designed to provide additional reserves at times

when the day’s reserve supply falls short of the banking system’s demand.

The system provides liquidity in times of crisis, ensuring financial

stability; and keeps reserve shortages from causing spikes in the market

federal funds rate, helping to maintain interest-rate stability.

7. Secondary credit is available to institutions that are not sufficiently sound

to qualify for primary credit. Banks may seek secondary credit due to a

temporary shortfall in reserves or because they have longer-term problems

that they need to work out.

8. Seasonal credit is used primarily by small agricultural banks to help in

managing the cyclical nature of farmers’ loans and deposits.

H. Reserve Requirements

1. By adjusting the reserve requirement, the central bank can influence

economic activity because changes in the requirement affect deposit

expansion.

2. Unfortunately, the reserve requirement turns out not to be very useful tool

of monetary policy because small changes in the reserve requirement have

large (really too large) impacts on the level of deposits.

3. Today, the reserve requirement exists primarily to stabilize the demand for

reserves and help the Fed to maintain the market federal funds rate close

to target; it is not used as a direct tool of monetary policy.

II. Operational Policy at the European Central Bank

A. The ECB’s Target Interest Rate and Open Market Operations

A. The ECB provides reserves to the European banking system primarily through

collateralized loans called refinancing operations.

B. In normal times, the main refinancing operation is a weekly auction of

two-week repurchase agreements (repo) in which the ECB, through the

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National Central Banks, provides reserves to banks in exchange for securities

and then reverses the transaction two weeks later. Since 2007, the ECB has

provided most reserves through longer-term refinancing at maturities of three

months and more.

C. The policy instrument of the ECB’s Governing Council is the minimum bid

rate allowed at these refinancing auctions; it is called the main refinancing

operations minimum bid rate.

D. The main refinancing operations minimum bid rate is the equivalent of the

Fed’s target federal funds rate and can be referred to as the target-refinancing

rate.

E. While the ECB’s refinancing operations are broadly similar to the Fed’s daily

open market operations, there are some differences, the most important being

that these operations are done at all the NCBs simultaneously (in the U.S. the

OMO is all done at the NY Fed).

F. Hundreds of banks participate in the ECB’s weekly auctions (as opposed to a

short list of 18 dealers for the Fed’s OMO).

G. Because of differences in the financial structure in different countries, the

collateral that is accepted in ECB refinancing operations varies from country

to country.

B. The Marginal Lending Facility

1. The Marginal Lending Facility is the analog to the Fed’s primary credit

facility, and through it the ECB provides overnight loans to banks at a rate that

is normally well above the target-refinancing rate.

2. As is the case with discount borrowing from the Fed, commercial banks

initiate these borrowing transactions when they face a reserve deficiency that

they cannot satisfy more cheaply in the marketplace.

3. The ECB’s system was the model for the redesign of the Fed’s discount

window.

C. The Deposit Facility

1. Banks with excess reserves at the end of the day can deposit them overnight at

an interest rate substantially below the target-refinancing rate.

2. This places a lower bound on the interest rate that can be charged on reserves.

D. Reserve Requirements

1. The ECB requires that banks hold minimum reserve levels based on the level

of liabilities they hold.

2. The ECB pays interest on required reserves. The rate is based on the interest

rate from the weekly refinancing auctions, averaged over a month, which is

designed to be very close to the overnight interbank rate.

3. The European system is designed to give the ECB tight control over the

short-term money market in the euro area, and it works. Compared to the

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United States’ federal funds rate, the European system is clearly more

successful in keeping the short-term interest rate close to target.

III. Linking Tools to Objectives: Making Choices

A. Desirable Features of a Policy Instrument

1. A good monetary policy instrument is easily observable by everyone, is

controllable and easily changed, and is tightly linked to the policymakers’

objectives.

2. These requirements leave policymakers with few choices, and over the years

central banks have switched between controlling the quantity and controlling

the prices.

B. Operating Instruments and Intermediate Targets

1. Operating instruments refer to actual tools of policy, instruments that the

central bank controls directly. Intermediate target refers to instruments that are

not directly under the control of the central bank but that lie between their

policymaking tools and their objectives.

2. Over the last two centuries, central bankers largely abandoned intermediate

targets, having realized that they didn’t make much sense.

3. Instead, policymakers focus on how their actions directly affect their target

objectives.

4. The vast majority of central banks choose to target an interest rate rather than

some quantity on their balance sheet. That’s because this keeps interest rates

from becoming overly volatile, which in turns stabilizes growth.

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