Tools of Monetary Policy
Fed — Policy tools — Impact on Interest Rates & Economic Activity
Fed controls the discount rate or the int paid on deposits which is typically set above and below
(respectively) the federal funds rate.
eg: Fed announces the target federal funds rate (FFR) at each FOMC meeting, the FFR affects
other interest rates throughout the economy.
How?
Tools 1. OMO. 1. Liquidity provision
2. Discount Policy. 2. Large scale asset purchases
3. Reserve Requirements. 3. QE and Credit Easing
4. Interest paid on reserves 4. Forward Guidance & commitment
to future policy actions.
Market for Reserves and Federal Funds Rate
Demand Curve
- Who demands qt of reserves - banks
- RR = rr x D & R = RR + ER
- Typically ior is fixed below the FFR
- If FFR < ior, banks will not lend in overnight
market, instead they will increase their holdings
of excess reserves
Supply Curve
- Non-borrowed reserves
- Borrowed reserves - discount rate
- Disc. rate kept at a fixed level over the FFR
- If FFR < id, then BR = 0 and supply = NBR
- If FFR > id, then banks will borrow from Fed
and use it to lend in the fed funds market at FFR
Equilibrium
- Supply of reserves = Demand for reserves
How Changes in the Tools of MP Affect the Federal Funds Rate
1. OMO - if the FFR > ior, an OM Purchase causes the federal funds rate to fall, whereas an open
market sale causes the federal funds rate to rise. If the FFR = ior, there is no impact on the FFR.
2. Discount Lending
1. If FFR < id, most changes in the id have no effect on the federal funds rate
2. If the FFR = id, then any reduction in id - will lower the FFR
3. Reserve Requirements
1. When the Fed raises reserve requirements, the federal funds rate rises
2. When the Fed decreases reserve requirements, the federal funds rate falls
4. Response to Change in Interest Rate Paid on Reserves
1. If the FFR > ior, then any changes in the ior has no effect on the FFR
2. If the FFR = ior, then any increase in ior, increases the FFR.
How the Fed’s Operating Procedures limit Fluctuations in the Federal Funds Rate
Federal Reserve's operating procedures limit the fluctuations of the federal funds rate so that it remains
between ior and id. If the range is kept narrow enough, then fluctuations around the target rate will be
small.
Conventional Monetary Policy Tools
Being the primary determinants of changes in interest rates, the MB and changes in MS
1. OMO remains the most important conventional tool.
Controlling the short term interest rates and the MS
OMO purchases … reserves… monetary base… money supply … short term interest rates
OMO sales … reserves … monetary base … money supply … short term interest rates.
OMO - 1. DYNAMIC - intended to change the level of reserves and the MB
2. DEFENSIVE - intended to offset movements in other factors that affect reserves and the MB
Dynamic or Defensive ? changes the level of MB or offsetting the movements in factors affecting the MB
If the Fed wants the increase the MS, it would buy bonds “dynamically”
If the Fed wants to keep the MS stable but also thinks that banks will replay a large discount loan, it would
buy bonds “defensively”
The FRBNY actually buys and sells government bonds
- Trading day - the staff looks at the reserve level, the Fed’s funds target and actual FFR,
expectations regarding floats, and treasury activities
- Treasury market conditions - check with primary dealers
- FRBNY determines how much to buy or sell and places appropriate order on the TRAPS
- TRAPS is a computer system that links primary dealers
- FRBNY selects the best offer and amount it wants to buy or sell
- Two types of sales - 1. Outright - bonds permanently join or leave the Fed’s B/S
2. Temporary - repos (MATCHED SALE - PURCHASE TRANSACTION) and
- reverse repos (agreement to buy/sell back at future date: 1-15 days)
- Such reversing contracts and liquidity of govt bond market render OMO a precise tool for
implementing the Fed’s MP (defensive tools)
2. Discount Policy and the Lender of Last Resort
- Primary Credit
- Secondary Credit Discount Loans
- Seasonal Credit
1. Primary credit was earlier called as adjustment credit facility ; here the discount rate was
typically set below the market interest rate.
Most important role. Better and sound banks can borrow large numbers overnight from this facility
SLF Standing Lending Facility LOMBARD facility
Usually, SLF is set higher than FFR (100 bsp higher)
Fed prefers that banks borrow from each other in the FF market so that they continuously monitor
each other for credit risks
Fed keeps SLR higher - backup source of credit/ liquidity
The primary credit facility thus puts a stop ceiling on the FFR at the discount rate.
2. Secondary Credit - given to banks under financial trouble or liquidity problems
- interest rate on SC is set typically higher than the discount rate (50 bsp usually)
- penalty
3. Seasonal Credit - agriculture areas or vocation banks
- to meet the needs of small number of banks that have a seasonal pattern of deposits.
- the int rate tied to the average of FFR and the CD rate
- considers discarding this credit due to improvements in credit markets
3. Lender of Last Resort
When the Fed was created , the most important idea was to be the lender of last resort in face of
financial panics and the system spinning out of control.
Earlier massive failures such as Great Depression - the Fed had not used discount tool . but in post war
period, Fed used this tools actively and massively. Preventing further bank failures
Role of FDIC. Proper to set up of FDIC, bank failure (in which a bank is unable to meet its obligation to
pay its depositors and other creditors - shut down) would require depositors to wait until the bank was
liquidated (all assets turned to cash) to get their deposit funds. Perhaps a fraction of their deposit could be
recovered. Depositors also has less information on the quality of assets the bank held, thus uncertainty
lead to panic and bank runs. Simultaneous failure of many banks led to sharp decline in bank lending,
bank panics have harmful consequences. Contagion Effect.
Government safety net - FDIC - guarantees that the current depositors will be paid in full on the first
$250,000 deposited in a bank if the bank fails.
- payoff method - purchase and assumption method
4. Reserve Requirements
We know, that increase in rr… slows down deposit creation … reducing the MS … decreasing mm
We know, that increase in rr… increases demand for reserves … increases the FFR
Thus, any increase in rr … will reduce MS … and will increase FFR
And, decrease in rr ,,, will increase the MS … and will reduce the FFR
Previously till 1930s, the reserve requirements were used often, this tool is now limited in use. Reserve
requirements are set under the Depository Institutions Deregulation and Monetary Control Act 1980.
All depository institutions Non-int bearing checking a/c
Commercial banks NOW a/cs require reserves on checking deposits
Savings and loans associations Super - NOW a/cs different reserve requirements for holding
MF saving banks and Credit Unions ATS - automatic Transfer Savings a/c deposits: 0%, 3%, 10%, 8-14% or 18%
5. Interest on Reserves
Fed started paying Interest on reserves in 2008
Generally the Fed has interest on reserves typically set below the Fed Funds Rate ior < FFR
Used as a floor rather than active tool
During crisis banks had huge excess reserves
By increasing ior … increasing FFR … reduced excess reserves
Advantages of Different Tools
We see that the OMO have 4 major advantages over other different tools
1. OMO - full control over their volume. This cannot be found under discount windows.
2. Flexible and Precise - can be used to exact desired extent. Small or large changes.
3. Easily reversed - mistakes can be corrected by reversing. Through OM Purchases if FFR falls too
low, the OM sales can be made.
4. Quick implementation - No admistrational delays , prior information, warings to make adjustments.
Reserve requirements - Therefore costly and burdensome. Rarely used.
When other tools have advantage over the OMO
1. When the Federal Reserve Bank wants to increase interest rate after banks have accumulated large
excess reserves. Then by influencing the FFR, by increasing ior, the FFR can be increased, and
ER can be reduced.
2. Discount window can be used as a lender of last resort.
Non-conventional Monetary Policy Tools
1. Liquidity Provision
- Discount Window Expansion
- Term Auction Facility
- New Lending Programs
2. Large-Scale Asset Purchases
3. Forward Guidance and Commitment to Future Policy Actions
Conventional monetary policy tools … expands the MS and… lower interest rates… NORMAL TIMES
During a full scale financial crisis, conventional monetary policy tools may not be effective
- Financial system sizes up
- Inability to allocate capital to productive uses
- Investments and spendings and economy collapse
- Negative shocks
People can always earn more from holding bonds than by holding cash … zero-lower-bound problem
…. nominal interest rates cannot be negative
non-interest rate tools - non-conventional tools
1. Liquidity Provision
a. Discount Window Expansion - around 2007, Fed lowered the discount rate to 50 bsp above the
FFR target from normally 100 bsp. By 2008, this was further lowered to 25 bsp above the FFR.
However, discount window is related to ‘stigma’ of borrowing under extreme situation or financial
distress. Use of discount window was limited during crisis.
b. Term Auction Facility - to encourage additional borrowings - TAF - rates determined through
competitive auctions. TAF was widely used - lower than id rates. Not looked as a penalty
c. New Lending Programs - extend credit beyond its traditional lending to banking institutions.
Investments to banks, promote use of commercial paper, mortgage backed securities, and other
asset backed securities.
Extended its B/S by over $1 trillion by the end of 2008, with expansion continuing after 2008.
Let’s go through the Fed’s Lending Facilities During the Global Financial Crisis …
2. Large-Scale Asset Purchases
Normally, purchase of short term government securities by 2008 Fed had started asset purchase
programs (referred to as LSAPS) to lower interest rates for particular types of credit
1. November 2008, the Fed started Government Sponsored Entities Purchase Program purchasing
$1.25 trillion of MBS guaranteed by Fannie Mae and Freddie Mac. Hoping to prop up the MBS
market by lowering int rates and reviving the housing market.
2. November 2010, Fed purchased $600 b of long term Treasury securities at the rate of about $75
b per month. This came to be called as QE 2. Intended to lower long-term interest rates.
Although the short-term int rates on Treasury securities hit the floor of zero. Remember: that long
term rates are more relevant to investment decisions than short term rates.
3. September 2012, Fed made its third large scale asset purchase program, QE 3 - $40 b MBS and
$45 b of long term Treasuries. And this was open ended -
3. Forward Guidance and Commitment to Future Policy Actions
During the FOMC 2008 - Management of expectations - forward guidance
Since the long term int rates are equal to the average of short term int rates that market expect to occur
over the life of a long term bond (remember from the expectations theory we studied many years ago) …
by keeping the FFR at almost zero (between 0 - .25%) for longer periods of time - Fed could lower the
market’s expectations of future short term int rates - thus causing the long term int rates to fall.
Conditional commitments
Unconditional commitments
“ the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of
federal funds rate for some time…”
2003 “ In these circumstances the committee believes that policy accommodation can be maintained for a
considerable period …”
2004 “policy accommodation can be removed at a pace that is likely to be measured…”
Through 2006 Fed raised FFR by exactly 0.25 % at every single meeting. .. unconditional commitment!
Quantitative Easing and Credit Easing
We saw unprecedented expansion of the federal reserve’s B/S. 2007 -2014.
With Fed’s assets growing $800 b to $4 tr. this expansion is the QE - increasing the MB
Usually such expansions result in an expansion of MS - a powerful force - economic expansion - inflation
over time
But can this be true all the time?
What if expansion in MB - ER? What if the FFR nears zero already?
Recall, from many years ago - example of Fed’s QE in 2008 and Bank of Japan’s QE after Japan’s stock
and real estate market bubble burst in 1990s - no recovery of economy - negative inflation.
So unconventional monetary policy tools are not effective?
Fed stance that such policies be looked at as Credit Easing and not exactly QE.
What does it mean by altering the composition of the Fed’s B/S?
CREDIT EASING - altering the composition of the Fed’s balance sheet in order to improve the functioning
of particular segments of the credit markets.
Say, the Fed provides liquidity to a particular segment of the credit market that has seized up - this
liquidity can help unfreeze - allocate capital to productive uses - generating economic productivity.
Say, the Fed purchases particular securities - increasing the demand for those securities -
lowering the int rate on those securities - as compared to other securities.
Therefore, even if the FFR have hit the floor to zero, asset purchases - lower interest rate for borrowers -
in particular credit market - stimulate spending -
