International Capital Markets

September 5/6, 2023

1. List some common features that central banks in the U.S., Eurozone, Japan and many other
counties have adopted in implementing monetary policy.

2. Has the approach described in the previous question been a success?

3. Promotors of cryptocurrencies such as bitcoin claim that central banks have incentives to “print
money” and therefore bitcoin meets a need for a reliable store of value that consumers can use
for transactions. What do bitcoin skeptics say about that?

4. What is the Fed’s mandate?

5. What is the ECB’s objective for monetary policy?

6. Suppose monetary policy succeeds in moderating the business cycle while keeping inflation
close to its target. What risks to the financial system might be intensified as a result? What
can be done about it?

7. Why do central bankers talk so much about their commitment to stable prices?

8. Do you think central banks should be in charge of bank supervision?

9. Why is it important that central banks are independent of other branches of government?

10. What is the difference between a secured and unsecured loan? What are the two main ways
that borrowers can provide security to lenders?

11. The Federal Reserve announced in 2020 that it would switch its target to “inflation averaging.”
What is it and how did it work out?

12. Central banks have tools in their “toolbox” beyond controlling the overnight (policy) interest
rate. What are

a. Forward guidance
b. Quantitative easing
c. Liquidity provision
d. Yield curve control.
13. Chair Powell said that the toolbox is more important than ever—not just for crises like the
Great Financial Crisis and the pandemic—but as routine instruments for implementing policy.
Why?

14. What did central banks do to stimulate the economy during the pandemic?

15. What are central banks doing to combat the recent bout of inflation?

16. Why weren’t central banks inclined to let inflation run for a while in 2022, stimulate the
economy during those difficult days and deal with inflation later?

17. How does QE in the US differ from the Eurozone and Japan?

18. What are the FOMC’s dots?

19. What can the U.S. president do to influence the Fed?

20. What is the Fed’s policy rate?

21. How does the Federal Reserve bring interest rates on overnight deposits in line with its target
rate?

22. A bank lends $100 million overnight to another bank or the Federal Reserve at an interest
rate, r. How much is the interest and when is it due?

23. What does it mean to pay a negative interest rate on an overnight deposit?

24. Suppose the Bank of Japan issued forward guidance, saying it would hike the overnight rate
after unemployment falls to 2.5%. One month, unemployment drops from 2.7% to 2.4%, but
the same month it was hit by a powerful typhoon. What would you expect?

25. The ECB and Fed have hiked quite a bit over the past year. They seem to have “broken the
back of inflation” and labor markets remain reasonably strong. What sort of forward guidance
are the ECB and Fed providing?

26. What can the Fed do to reduce inequality?

27. The U.S. Federal Reserve earned hundreds of billions of dollars from QE. How?

28. Why didn’t the ECB continue to ease by lowering the target below zero, say to −5%?

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29. Which is more secure for a money market investor – an overnight bank deposit or an overnight
repurchase agreement?

30. How can investor/lender lose money on a repo?

31. How does a haircut protect lenders on repo?

32. A securities dealer has been invited to bid on a government security. What method is it most
likely to use to finance the purchase?

a. repo
b. bank loan

33. Describe how a conservative money market investor might participate in the repo market.

34. What is SOFR?

35. Why would anyone invest in a (reverse) repo when SOFR is 10 bps less than the Federal
Reserve pays on reserves?

Answers

1. These central banks have set up monetary policy committees that (i) are generally independent
from domestic politics; (ii) meet periodically on a published schedule; (iii) fix or set short-term
(usually overnight) interest rates that they can control, and usually leave these rates unchanged
between meetings; (iv) are transparent, issuing press releases after each meeting that affirm the
bank’s overriding commitment to price stability, announce whether the benchmark rate will
change, offer a brief rationale for the decision, reporting the votes of the individual members
and holding a press conference. The Turkish central bank, under control of the President, tried
to tame inflation by lowering interest rates; this failed, and now Turkey appears to be coming
around to more orthodox policies.

2. Yes. Inflation has been lower and steadier than ever before, with the exception of the past two
years. This applies to developed and developing countries. The past two years have been beset
by inflation above the target in many countries for several reasons including: supply chain
bottlenecks arising from the pandemic, energy price shocks following Russia’s invasion of

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 Ukraine, and consumers flush with cash from various stimulus programs. Monetary policy
responded and inflation is rapidly dropping.

3. See the answer to the previous question. The evidence is more compelling now than ever before
that an independent central bank will stick to its mandate: an inflation target over the medium
term. (The price of bitcoin by contrast is extremely volatile.) It is false to claim that central
banks have incentives to print money; their job is defined in terms of price stability.

4. The Fed has a “dual mandate”: promoting maximum employment and stable prices. However,
as the Fed says, “Stable prices in the long run are a precondition for maximum sustainable
output growth and employment …” Since monetary policy is ultimately one instrument, it can
only hit one target. Clearly, price stability—defined as 2% inflation over the medium term—
is the priority. It has defined this goal as symmetric: 1.5% inflation is as bad as 2.5%.

5. The ECB is the central bank for the Eurozone. It targets the Harmonized Index of Consumer
Prices (HICP) at a symmetric target of 2% over the medium term. The HICP measures prices
broadly throughout the twenty countries in the Eurozone. The ECB does not focus on specific
countries any more than the Federal Reserve cares about CPI in particular U.S. states. (Note:
you don’t have to memorize the term “HICP” or the number of countries in the Eurozone.)

6. As Fed Chair Powell said recently, “One result [of better monetary policy] has been much
longer expansions, which often brought with them the buildup of financial risk.” That is, banks
and other financial institutions feel safer taking more risks if they feel less concerned about the
business cycle; but these risks can get out of hand. The solution is tough prudential regulation.
This means regulators require adequate capital and many risk controls.

7. Central banks frequently affirm their overarching commitment to stable prices and try to do so
in plain language. Managing expectations is part of maintaining stable prices. Central bankers
fear that inflationary expectations might be self-fulling, at least for a time: firms would raise
prices in anticipation of inflation while workers would raise their nominal wage demands.

8. There are valid arguments on both sides of this question. The arguments in favor of putting the
central bank in charge are twofold. A former Fed Chair, argued to the U.S. Congress on behalf
of keeping regulation of bank holding companies at the Fed:

(1) the expertise and information that the Federal Reserve develops in the making of
monetary policy enable it to make a unique contribution to an effective regulatory
regime; and (2) active involvement in supervising the nation’s banking system allows
the Federal Reserve to better perform its critical functions as a central bank.

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 The Fed regulates bank holding companies in the U.S, although banks themselves have other
regulators. Japan keeps regulatory and monetary policy functions separate; they were formerly
separate in the U.K. and Eurozone, but have switched to a model closer to the U.S. Amar Bhidé
argued in a Wall Street Journal op-ed that the U.S. should simplify the Fed’s mandate rather
than loading it up with even more responsibility:

[W]e should think of how best to dismantle an overextended Fed. Though advanced
economies like ours require organizations capable of taking on a wide range of
activities, there are limits… Good judgment requires experience, not just exceptional
intelligence or raw ability. Although many lessons about managing people can be
applied to different fields, good judgment also requires some specific expertise. You
can’t manage plumbers without knowing something about plumbing… [T]he Fed has
been incapacitated by its transformation into an omnibus enterprise with
responsibilities ranging from boots-on-the-ground regulation to high-level monetary
policy.

9. Independence enables them to stand up to any pressure to stimulate the economy around an
election cycle. If such pressures exist, the market will expect the central bank to yield, so
inflation expectations will be entrenched and self-fulfilling.

10. Unsecured means that the lender is relying on the general willingness and ability of the
borrower to repay the loan on its terms. If the borrower fails to repay, the lender must file a
lawsuit and may even need to force the borrower into bankruptcy and pursue its rights as a
creditor. Secured lenders benefit from collateral. A borrower can transfer possession of
collateral, such as a repo of marketable securities, to the lender when the loan is initiated. If
the borrower defaults, the lender can sell the collateral and be made whole again. Alternatively,
the collateral can be the pledge of an asset, such as property; if the borrower defaults, the lender
theoretically has the legal right to foreclose on the collateral and sell it.

11. Historically, the Fed like other central banks would let “bygones be bygones.” If inflation
undershot 2%, it would still shoot for 2% going forward. With inflation averaging, if inflation
runs at 0.8% in one year, it will presumably target 3.2% in the next. The Fed, though, never
spelled out the details and seems to have abandoned the idea.

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12.
a. During forward guidance, a central bank communicates its intentions regarding future
short-term interest rates, sometimes contingent upon the performance of
macroeconomic variables (e.g., inflation, employment). Because expected short-term
rates partially determine long-term rates, forward guidance can help lower long-term
rates right away.
b. After lowering the overnight rate to zero or near-zero, continue to provide monetary
stimulus by purchasing securities and raising the money supply. Major central banks
used QE during the Great Financial Crisis and are then again it during the pandemic.
c. The Fed, ECB and other central banks provided longer-term funding, from one month
to three years, to financial institutions so they wouldn’t worry about running out of
money. To protect the central banks in case the banks defaulted on the loans, the
central banks took on marketable securities as collateral. These are term repos.
d. Yield curve control means the central bank buys long-term government bonds, maybe
selling short-term bonds at the same time. This brings down long-term interest rates.
(If this is not clear to you now, it will be in a few weeks.) This is the least popular
among the tools, except in Japan.

13. With interest rates lower than they used to be, the Fed’s traditional tool—lowering interest
rates—can have less impact than before. That is, if short term interest rates are 1% and the
economy runs into a severe recession, the Fed can only lower it from 1% to around 0%. To
meet its statutory mandate for maximum employment, it may need to turn to other tools.

14. Quickly lowered interest rates to zero or slightly negative (if they weren’t already there pre-
pandemic). They adopted forward guidance: promising to keep rates low “for some time” or
“until the inflation has sustainably risen to the target.” (That didn’t take long!) They have
engaged in massive QE, buying up government bonds and mortgage-backed securities or, in
some cases, also corporate bonds.

15. In Europe, the U.S. and many other countries except Japan, central banks have started raising
their policy rate and signaled. They have done what they can to contain inflationary
expectations with tough talk. To varying degrees, they have started “normalizing” their balance
sheets—selling securities they acquired during QE or at least letting bonds mature without
replacing them.

16. Once inflation expectations are embedded in wage-setting and firms’ pricing policies, it is
costly to reverse. Central bankers agree that the costs are lower to keep expectations contained.

17. The Fed buys securities issued by the US Treasury and government sponsored agencies. The
ECB and Bank of Japan buy government bonds plus securities issued by private companies.

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 The Bank of Japan even buys equities (stock). Japan’s QE is much larger than the others
relative to the size of its economy.

18. FOMC participants anonymously predict what they expect for the Fed target rate at different
points in the future. Each participant, including Chair Powell, gets one dot.

19. Not much. Trump tried. We learned that he couldn’t remove a governor, except “for cause”
such as personal misconduct. He insulted the Fed, but they just ignored him. He threatened to
fill the Fed with unqualified governors if the FOMC didn’t cooperate with him, but Congress
wouldn’t approve their nomination.

20. Technically, the FOMC sets “target federal funds rate.” The target refers to the rate at which
banks borrow and lend overnight in USD. Lately, this has been expressed as a range rather
than a single point. Currently the lower band is 5.25% and the upper band is 5.50%. The FOMC
also sets the interest rate paid to banks on overnight deposits held at the Fed: IORB = interest
on reserve balances. IORB lies inside the bank. It is currently 5.40%. [Note to students: You
don’t have to memorize these rates.]

21. The Federal Reserve cannot dictate that banks borrow and lend at the target rate, but the IORB
anchors their marginal cost of funds. A bank with access to the Federal Reserve would not
deposit in another bank for less than it could get from the Fed. Ordinarily, banks keep plenty
of reserves at the Fed that they can draw down when they need immediate cash; the interest
rate they forego is the IORB. If market interest rates were above the IORB, the Fed would
bring rates down by buying securities, thereby increasing the supply of reserves (money).

22. Assume today is a “good business day,” in the sense that the payments system is open. The
loan starts today. It ends matures in n days on the next good business day. If today is Monday
– Thursday and tomorrow is a good business day, then n=1. If today is Friday and Monday is
a good business day, then n=3. If today is Friday and Monday is a holiday, then n=4. The
interest = $100,000,000 × n × r / 360. It is paid on the same day the loan is repaid.

23. The lender pays interest to the borrower. When EUR rates were negative, a lender of €100
would receive less than €100 at the end of the loan.

24. They would wait before taking action. You can’t rely on data collected during a natural
disaster; for example, people may have been hired as temporary relief workers or non-
randomly failed to respond to the survey. These committees are run by humans who are meant
to employ expert judgment based on the conditions at the time.

25. Given all the uncertainty, it would not be credible, for example, to pledge to keep raising rates
until inflation declines or something like that. Central banks are all saying that they are “data

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 dependent.” Nothing is written in stone, they will react to the data as it arrives. At the same
time, they underscore their commitment to contain inflation until the job is done.

26. It can tolerate more inflation than is comfortable for a time, permitting the labor market to
overheat. The idea is that a tighter market and higher wages will draw in workers who were
out of the labor force and thus develop attachment to the labor market that will persist over the
long term. There is evidence that it works. The Fed can squeeze “hysteresis” into its mandate
by arguing that it promotes maximum employment. Of course, the Fed will also argue that its
main contribution to economic wellbeing is establishing stable prices over the medium term,
that fiscal policy and public policy generally are much better than monetary policy at
“address[ing] distributional, disparate outcomes.”

27. Banks held multi-trillion dollars in reserves at the Fed on which the Fed paid interest rates as
low as 0.25%. It invested the money in Treasury and mortgage-backed securities that yielded
much more. (This is not a surefire way of making money, though. If the Fed has to hike, its
cost of borrowing will rise at the same pace and might rise above the yield on its securities
portfolio.) The Fed does not try to make a profit—this is not its mandate. The profit is a
consequence of its portfolio holdings.

28. Banks with a negative 5% interest rate would return approximately €95 for every €100 placed
on deposit for one year. Rather than depositing in these banks, people would hoard currency.
Interest rates can dip a bit below zero as a kind of storage cost for holding cash, but probably
not much below -1%. In addition, since banks have trouble passing on negative interest rates
to their depositors, very low negative interest rates could cause banks to lose money.

29. In general, a repo is safer, since it is collateralized by a high-grade security. The investor can
sell this collateral if the repo counterparty can’t repay the loan.

30. Two things both have to happen: the repo counterparty fails to repurchase the collateral and
the value of the collateral falls before the lender can sell it.

31. A haircut reflects the difference between the size of the repo and the value of the collateral. It
provides further margin of safety for the lender if the “repo counterparty” defaults (i.e., fails
to repurchase the collateral at the agreed price). To sharpen the answer to the previous question:
we could say, “the repo counterparty fails to repurchase the collateral and the value of the
collateral falls by more than the amount of the haircut before the lender can sell it.

32. a. Repos command lower interest rates than bank loans and can be arranged more quickly—
the dealer can enter into a repo instantly with its regular counterparties.

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33. Money market investors frequently enter into repurchase agreements (or “reverse repurchase
agreements,” from the investors’ perspective). They buy securities with an agreement to resell
them at a fixed price on a date in the near future.

34. According to the Fed, SOFR “is a broad measure of the cost of borrowing cash overnight
collateralized by Treasury securities. … The SOFR is calculated as a volume-weighted median
of transaction-level … repo data... Each business day, the New York Fed publishes the SOFR
on the New York Fed website...” Each morning when the Fed publishes the rate, transactions
refer to the previous day.

35. Because they’re not a bank and don’t have access to the Fed.