Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Conceptual and Analytical Problems Explain how the Federal Reserve would implement a rise in the target range for the federal funds rate? How does its action influence the market federal funds rate? Answer: The Federal Reserve would increase the interest rate on excess reserves (IOER), an interest rate that it controls directly. This raises the minimum rate at which banks would be willing to lend because they can earn the IOER rate risk-free by depositing these funds with the Fed. Some lenders in the federal funds market are not banks and so are not eligible to earn the IOER rate. An increase in the IOER rate raises the rate at which banks would be willing to borrow from these nonbank participants in the federal funds market in order to deposit these funds at the Fed and earn the IOER rate. The increase in the IOER rate therefore puts upward pressure on the market federal funds rate to bring it into the new higher target range. Using a graph of the market for bank reserves, show how, in the post-2008 environment, the Federal Reserve can control independently both the price and quantity of aggregate bank reserves. Answer: Figure 18.4 can be used to illustrate this point. The Fed can control the price of aggregate reserves in the market for reserves by changing the interest rate it pays on excess reserves. When the Fed pays a higher rate, for example, banks would be willing to pay a higher rate to borrow from nonbank participants in the federal funds market in order to deposit these funds at the IOER at the Fed. This process does not change the supply of aggregate reserves. It is reflected in an upward shift in the flat portion of the reserve demand curve. Because there is an abundance of excess reserves in the banking system, banks’ demand for reserves is not sensitive to changes in reserve supply within a certain range (the flat portion of the reserve demand curve). In this range, the Fed can change the supply of reserves without influencing their price. Consider a scenario where, over the next 10 years, the supply of aggregate bank reserves shrinks enough so that the reserve supply curve intersects the downward sloping part of the reserve demand curve and the Federal Reserve reverts to its pre-crisis implementation method for influencing the federal funds rate. Use a graph to illustrate and explain how the Federal Reserve would bring about a reduction in the federal funds rate. In this scenario, would it be possible to control independently both the price and quantity of reserves? Answer: This can be illustrated in a graph similar to Figure 18.2. If the reserve supply curve intersects the downward sloping part of the reserve demand curve, shifting the reserve supply curve will alter the equilibrium federal funds rate. To reduce the federal funds rate, the Fed could announce a decrease in the federal fund rate target and carry out an open market purchase of securities. This increases the aggregate supply of reserves, shifting the reserve supply curve to the right and lowering the equilibrium federal funds rate. Under this scenario, the Fed would not be able to control independently the price and quantity of reserves: it had to change the supply in order to hit the desired price. Why might the market federal funds rate deviate from the interest rate on excess reserves? Answer: The main reason that the market federal Funds rate might deviate from the interest rate on excess reserves (IOER rate) is that some participants in the market for federal funds are not depository institutions and so are not eligible to earn the IOER rate. These participants include government-sponsored enterprises (GSEs) such as Freddie Mac and Fannie Mae and the Federal Home Loan Banks. Because they do not have the option to place excess funds on deposit at the Fed as reserves and earn the IOER rate, they may be willing to lend those funds at a lower rate than the IOER rate in the federal funds market. Partly as a result, the equilibrium federal funds rate is below the IOER rate. The overnight reverse repo rate (ON RRP) is a supplementary monetary policy tool of the Federal Reserve. Explain how this tool can set a floor under the market federal funds rate. Answer: Even if they are not eligible to earn the IOER rate, many nonbank participants in the federal funds market, such as government-sponsored enterprises (GSEs), can engage in overnight reverse repo transactions with the Federal Reserve and earn the overnight reverse repo (ON RRP) rate. ON RRPs are riskless loans to the Federal Reserve. As long as the Fed is willing to engage in a sufficient volume of these transactions, these nonbank participants will not be willing to lend in the federal funds in the market at a rate below the riskless ON RRP rate. Federal Reserve buying of mortgage-backed securities is an example of a targeted asset purchase. Explain how the Fed’s actions are intended to work. Answer: The Fed wishes to stimulate the housing market. Housing prices and activity collapsed in the 2007-2009 episode, serving as a key driver of the crisis. By purchasing mortgage-backed securities (MBS), the Fed sought to lower mortgage rates in order to boost home sales, raise house prices, and assist housing construction. Putting a floor under MBS prices also helped restore confidence in financial firms that held many real estate-related assets and had depleted their capital. The strategy of inflation targeting, which seeks to keep inflation close to a numerical goal over a reasonable horizon, has been referred to as a policy of “constrained discretion.” What does this mean? Answer: Under inflation targeting, central banks conduct policy to attain the inflation goal. However, the targets may specify an acceptable range around the central target. In addition, the strategy typically aims to achieve the inflation objective over an extended period of time, which allows policymakers some leeway in determining the pace at which the target should be achieved. Still, the announcement of a target constrains policymakers’ choices, because policy credibility is diminished if central bank fails persistently to achieve the target. The charge given by Congress to the Federal Reserve is to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Discuss whether the Taylor rule conforms to this mandate. Answer: The mandate given to the Federal Reserve by Congress is embedded in the Taylor rule. First, if the inflation target π*, is low, the inflation gap term satisfies the “stable price” component of the congressional mandate. Second, employment generally rises and falls as output fluctuates around its long-run trend given by potential output. If employment is at its “normal” or “maximum sustainable” level when output (real GDP) is at its “normal” (potential) level, then the output gap term incorporates the employment mandate. Finally, if inflation is low and near the target, then long-term interest rate should be “moderate.” 9. Use the following Taylor rule to calculate what would happen to the real interest rate if inflation increased by 3 percentage points. Target federal funds rate = Natural rate of interest + Current inflation + ½(Inflation gap) +½(Output gap) Answer: If actual inflation goes up by 3 percentage points, the target (nominal) federal funds rate goes up by 4.5 percentage points (3 percentage points due to the direct impact of inflation and another 1.5 percentage points due to an increase in the inflation gap). To calculate the impact on the real interest rate, we can use the Fisher equation Nominal interest rate = Real interest rate + Expected inflation So, if the nominal rate increases by 4.5 percentage points and expected inflation increases by 3 percentage points, the real interest rate must have increased by 1.5 percentage points. 10. The Taylor rule in Problem 9 is thought to be a reasonably good description of policy behavior in the United States in the absence of unusual financial market conditions or deflationary worries. Taking into account what you know about the policy goals of the ECB, how would you amend the Taylor rule to better approximate policymaking behavior by the ECB? Answer: The ECB has a hierarchical mandate where price stability is accorded greater importance that other policy goals. Consequently, a weight on the inflation gap greater than ½ may be more appropriate in the ECB’s case. Although the primary objective of the ECB is to maintain price stability, the central bank is sensitive to output fluctuations, so the weight on the inflation gap should remain less than 1. 11. Go to the website of the Federal Reserve Board at www.federalreserve.gov and find the section describing monetary policy tools. Which unconventional tools employed during the financial crisis of 2007–2009 has the Fed stopped using? What do you think determined the order in which various facilities were shut down? Which, if any, of the tools still remain in operation? Answer: On www.federalreserve.gov/monetarypolicy/expiredtools.htm the Fed reports that the following policy tools have expired as of 2013: (1) the Money Market Investor Funding Facility; (2) the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; (3) the Commercial Paper Funding Facility; (4) the Primary Dealer Credit Facility; (5) the Term Securities Lending Facility; (6) the Term Auction Facility; (7) Term Asset-Backed Securities Loan Facility and (8) the Maturity Extension Program. The first of these expired on October 30, 2009; programs 2 through 5 expired on February 1, 2010; program 6 ended with its final auction on March 2010; program 7 was closed for new loan extensions in June 30,2010, and program 8 on December 31, 2012. Details on each are available at the website noted above. The order in which the facilities shut down reflects the sequence in which the problems they were designed to fix were resolved. For example, liquidity-providing programs shut down when market liquidity conditions improved, the commercial paper funding facility was closed when that market became functional again. Mortgage-backed securities purchased as part of the Fed’s targeted asset purchases remained on the Fed’s balance sheet as of November 2016, although the Fed’s holdings of mortgage-backed securities has declined. 12. Use your knowledge of the problems associated with asymmetric information to explain why, prior to the change in the Federal Reserve’s discount lending facility in 2002, banks were extremely unlikely to borrow from the facility despite funds being available at a rate below the target federal funds rate? Answer: Participants in the federal funds market do not have full information about each other, so signals about the well-being of borrowers played a very important role. If a bank borrowed from the discount window, it could be interpreted by other banks as a signal of trouble, even if the borrowing bank is sound. In this case, other participants in the federal funds market would be unwilling to make uncollateralized loans. To avoid sending a signal of fragility, borrowing banks were willing to pay higher interest rates for funds in the marketplace. Based on the liquidity premium theory of the term structure of interest rates, explain how forward guidance about monetary policy can lower long-term interest rates today. Be sure to account for both future short-term rates and for the risk premium. How does the effectiveness of forward guidance depend on its time consistency? Answer: The liquidity premium theory expresses the long-term interest rate as the sum of average expected future short-term rates and a liquidity risk premium: i_nt= (i_1t+ i_(1,t+1)^( e)+⋯+ i_(1,t+n-1)^e)/n+ rp_n When credible, forward guidance influences expectations about future short-term rates. For example, if policymakers credibly express intent to keep interest rates low for several years, this forward guidance can lower the numerator of the first term on the right-hand side of the equation. A credible intention to keep rates steady also can lower the risk premium (the second term on the right-hand side of the equation) by reducing interest rate risk. However, if forward guidance lacks time consistency, it also would lack credibility, making it ineffective. Instead of lowering market interest rate expectations, investors may simply expect the central bank to renege on the policy commitment to keep rates low and steady in the future.
With the policy interest rate at the effective lower bound, how might a central bank counter unwanted deflation? Answer: Several unconventional policy options exist, including forward guidance, quantitative easing and targeted asset purchases. These can be used individually or in combination. For example, combining forward guidance and quantitative easing, the central bank might commit to expand its asset holdings (say, through large-scale asset purchases) until inflation reaches an acceptable level. Or, in order to stimulate spending, it might announce its willingness to tolerate inflation temporarily above its medium-term objective, hoping to lower the expected real interest rate. 15. Outline and compare the ways in which the Federal Reserve and the ECB added to or adjusted their monetary policy tools in response to the financial crisis of 2007–2009 and subsequent financial crisis in the euro area. Answer: The Federal Reserve set up a host of lending facilities such as the Term Auction Facility, the Primary Dealer Credit Facility and the Commercial Paper Funding Facility (see Table 18.2 for a complete list) to enable them to lend to more counterparties against a wider range of collateral for longer periods and to intervene directly in more markets. The Fed’s response covered all three categories of unconventional monetary policy tools: it used quantitative easing, expanding its balance sheet significantly in the wake of the Lehman Bros collapse in September 2008, targeted asset purchases, including the purchase of over $1 trillion in mortgage-backed securities, and forward guidance in FOMC statements that low policy rates may be warranted by economic conditions for some time. The Fed also started to pay interest on reserves and narrowed the spread between the discount rate and the target fed funds rate. In both crises, the Fed provided dollar liquidity swaps to other central banks which, in turn, extended dollar funding to their financial intermediaries. Currently, the Fed specifies a target range for the Federal Funds rate, with the interest on excess reserves forming that range's upper limit. Reserves are so abundant that small open market operations would have little to no effect on the federal funds rate, resulting in the IOER rate replacing OMOs as the principle tool in tightening monetary policy. In both crises, the ECB used dollar liquidity swaps from the Fed to provide dollar funding to euro-area banks. In the latter part of 2008, the ECB switched from using variable rate tenders to fixed rate tenders for its main refinancing operations. Over time, it widened markedly the range of acceptable collateral and lengthened the term of key refinancing arrangements to as long as three years. By early 2013, most of its liquidity supply was longer term. The ECB engaged in targeted asset purchases by buying covered mortgage bonds, albeit to a much lesser extent than the Fed. The ECB also made limited open-market purchases of bonds issued by governments on the periphery of the euro area. Perhaps most important, it promised in September 2012 to purchase without limit the short-term debt (up to three years in maturity) of euro-area governments that accept a restrictive program of fiscal supervision. The ECB also narrowed the spreads between its main refinancing rate and the marginal lending facility rate (its counterpart to the discount rate) to 25 basis points (at the start of 2016). It also allowed the market overnight rate to sink well below the official target rate. In June, 2014, the ECB set its deposit rate slightly below zero, yet banks did not switch from holding reserves to holding cash, which would have made the negative rate contractionary. Similar to the Fed's IOER, this deposit rate drives the target refinancing rate now that reserves are plentiful and the auctions of repos are less effective. Unlike the Fed, the ECB generally has not provided forward guidance regarding the future level of the policy rate. 16. How might the Federal Reserve exit from the unconventional policies it employed during the financial crisis of 2007–2009 without causing inflationary problems? Answer: The Fed could tighten monetary policy without selling assets by raising the deposit rate it pays on reserves. As the deposit rate sets a floor to the market fed funds rate, the fed funds rate would rise to this level even if the supply of reserves is unchanged. 17. The central bank of a country facing economic and financial market difficulties asks for your advice. The bank cut its policy interest rate to the effective lower bound, but it wasn’t enough to stabilize the economy. Drawing on the actions taken by the Federal Reserve during the financial crisis of 2007-2009, what might you advise this central bank to do? Answer: You should advise the central bank to use unconventional monetary policy tools. This could include expanding its balance sheet significantly, providing aggregate reserves beyond the level needed to lower the policy rate to zero (quantitative easing). It might intervene directly in markets the central bank is not usually in, such as the commercial paper market, or lend directly to non-bank institutions if it has the power. It might alter the composition of its balance sheet, purchasing risky assets that are creating bottlenecks for intermediaries (targeted asset purchases). It could also inform markets of its commitment to keep interest rates low (forward guidance). 18. Suppose ECB officials ask your opinion about their operational framework for monetary policy. You respond by commenting on their success at keeping short-term interest rates close to target but also express concern about the complexity of their process for managing the supply of reserves. What specific changes would you suggest the ECB should make to its system in the future? Answer: As national markets become more integrated, and the euro-area financial crisis recedes, you might suggest that the ECB concentrate its operations in Frankfurt instead of having to coordinate these operations at all the national central banks simultaneously. This integration would greatly simplify the process. You might also suggest that the ECB narrow the list of institutions that qualify as counterparties to open market operations and reduce the range of assets it accepts as collateral for these operations. You could mention that the need for such changes will become more urgent as more countries join EMU.
19. In June 2014, the European Central Bank (ECB) cut the interest rate it pays on excess reserves below zero. What was the rationale for this move and why would banks be willing to pay to keep deposits with the ECB? Answer: The ECB cut the rate in an effort to provide further monetary accommodation. The deposit rate acts as a floor for the ECB’s target refinancing rate, so lowering it below zero allowed for the policy rate to fall. Banks are willing to pay a fee to keep their reserves on deposit at the ECB because the alternative of holding their reserves in the form of cash in their vaults also is costly. The transactions costs of using cash include storage, transport and insurance. 20. Inflation, rather than the price level or nominal GDP, is the policy target of choice for many of the world’s central banks. Provide a reason why you think this is the case. Answer: Inflation uncertainty would likely be higher under price level targeting or nominal GDP targeting than under inflation targeting, thus making it more difficult for consumers and businesses to make decisions about the future. Data Exploration Plot the Taylor Rule since 1990 on a quarterly basis (similar to Figure 18.7). For the output gap, use the percent deviations of real GDP (FRED code: GDPC1) from potential output (FRED code: GDPPOT). For inflation, use the percent change from a year ago of the price index for personal consumption expenditures (FRED code: PCEPI). Assume that the long-run risk-free rate is 2 percent and the target inflation rate is 2 percent. When complete, compare the Taylor Rule rate against the actual federal funds rate (FRED code: FEDFUNDS) after 2007. Answer: The data plot is: Notice that the Taylor rule turns sharply negative in 2009 and 2010, but the federal funds rate does not sink below zero. The effective lower bound on nominal rates helps explain why the Federal Reserve employed unconventional monetary policy tools, including forward guidance, quantitative easing and targeted asset purchases. On December 15, 2015, the FOMC raised the target range for the market federal funds rate by 25 basis points (bp) to a range of ¼ to ½ percent. It also instructed the Open Market Desk at the Federal Reserve Bank of New York to engage in overnight reverse repurchase agreements (ON RRPs) with eligible participants at an offering rate of ¼ percent. To see the impact, plot (on a “Weekly, ending Wednesday” basis beginning July 15, 2015) the interest rate on excess reserves (FRED code: IOER) and the effective federal funds rate (FRED code: FF). Explain the plot, noting the impact of the FOMC decision on these two interest rates as well as the implicit role played by the offering rate on ON RRPs.
Answer: The data are plotted below. No bank will lend below the IOER rate when it can earn the risk-free IOER rate by making deposits at the Fed. However, some financial intermediaries like government-sponsored enterprises (GSEs) are not eligible to earn interest from the Fed. These institutions lend in the federal funds market to earn positive interest overnight on their funds. Banks can borrow at this market federal funds rate and deposit it at the Fed, but doing so involves some cost, so they do not bid the market federal funds rate all the way up to the IOER rate. On the day of the December 2015 FOMC meeting at which the IOER was raised to 0.50 percent, the market federal funds rate rose by about 20 basis points. The increase in the funds rate also partly reflects the ¼ percent offering rate by the Fed for ON RRPs; the GSEs can lend at the ON RRP rate and so will not lend to anyone at a lower rate. Thus, in practice, when the Fed offers ON RRPs in sufficient quantity, the offering rate sets a floor on the funds rate, as the experience after the FOMC meeting indicates. Assess the impact of targeted asset purchases by plotting since 2003 on a monthly basis the Federal Reserve’s holdings of mortgage-backed securities (FRED code: MBST) and (on the right scale) the average yield on 30-year fixed-rate mortgages (FRED code: MORTGAGE30US). Discuss how these purchases might support both the housing market and the banking system. Answer: The data plot below shows the mortgage rate for several years prior to the onset of this targeted asset program. As the Fed purchases these bonds, mortgage rates gradually fall. Lower mortgage rates stimulate the housing market by making home purchases more affordable. The program also benefits banks by raising the prices of real estate-related assets that they hold, buttressing their capital positions. In 2002, the Federal Reserve began to set the discount rate above the federal funds rate, reversing its previous practice of keeping the discount rate below the funds rate. To assess the impact, plot on a monthly basis from 1990 to 2007 the difference between the federal funds rate and the discount rate before (FRED codes: FEDFUNDS and MDISCRT) and after the policy shift (FRED codes: FEDFUNDS and WPCREDIT), using the same line color. On the right scale, plot the level of discount window borrowing (FRED code: DISCBORR). Did the new penalty rate for discount loans significantly diminish borrowing? What might account for the behavior of discount window borrowing? Answer: Prior to 2002, the federal funds rate was above the discount rate, but banks borrowed relatively little from the Fed. Moreover, the volume of borrowing did not change meaningfully after the discount rate was set above the federal funds rate. The explanation must be due to other factors (“nonpecuniary factors”) that influence banks’ willingness to borrow from the Fed or from the open market. Even when the discount rate is relatively low, banks are reluctant to borrow from the Fed because they fear the “stigma” of being identified as a fragile institution with a weak balance sheet. That perception among a bank’s counterparties could reduce its access to market funding or make it prohibitively expensive. Examine the real interest rate in Japan, plotting since 2000 the nominal interest rate on Japanese Treasury bills (FRED code: INTGSTJPM193N), the inflation rate based on the percent change from a year ago of Japan’s consumer price index (FRED code: JPNCPIALLMINMEI), and an estimate of the real interest rate based on the difference between these two indicators. Comment on the lengthy period of positive real rates since 2000 and the role of deflation in these rates. Comment on the risks that deflation poses in an economy with nominal interest rates at the effective lower bound. Answer: If expected inflation is equal to the inflation rate measured as the percentage change from a year ago of the consumer price index, then the red line is a measure of the real interest rate. As in the Fisher equation, when the nominal rate is zero, the real interest rate is the negative of the inflation rate. Consequently, the real rate rises when deflation worsens. Such a rise of the real interest rate can trigger a vicious circle of declining economic activity, intensifying deflation, and further increases in the real interest rate. To avoid this vicious circle, a central bank may adopt unconventional policy tools to lower the real interest rate and stimulate economic activity. In 2014, a consumption tax hike temporarily boosted the measured inflation rate in Japan; as a result, with nominal rates continuing at zero, the measured real rate appeared very negative. However, as of 2016, CPI inflation again subsided, raising the measured real interest rate. Organization for Economic Co-operation and Development, Consumer Price Index of All Items in Japan© [JPNCPIALLMINMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNCPIALLMINMEI. International Monetary Fund, Interest Rates, Government Securities, Treasury Bills for Japan© [INTGSTJPM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTGSTJPM193N indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
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