New Operating Framework for Monetary Policy Implementation

Size: px

Start display at page:

Download "New Operating Framework for Monetary Policy Implementation"

Adele Sherman
5 years ago
Views:

1 New Operating Framework for Monetary Policy Implementation Juan Francisco Rubio Ramirez Emory University Federal Reserve Bank of Atlanta XXV Ciclo de Jornadas Económicas del Banco de Guatemala

Fed purchased long-term Treasuries and mortgage-backed securities. 2.5 Trillions $ Assets 2 1.

2 Expansion of Balance Sheet During the financial crisis, fed introduced a number of liquidity facilities. Moved from ONLY monetary policy to BOTH monetary and liquidity policy. Fed purchased long-term Treasuries and mortgage-backed securities. 2.5 Trillions $ Assets Short Term Lending to Financial Firms Rescue Operations MBS & Agency Debt 1 Targeted Lending Programs 0.5 Treasury Securities Source: Federal Reserve 2

3 Evolution of central bank balance sheets Index: January 2007=1 6 Federal Reserve 5 Bank of England 4 3 Bank of Japan 2 ECB Data through March 2016, Source: Bank of England, Bank of Japan, European Central Bank, Federal Reserve Bank projections through Dec 2016

4 The Big and the Really Big Central Bank Assets as a share of GDP percent Japan United Kingdom Euro Area United States through 2015, except UK through 2014 Source: Bank of England, Bank of Japan, European Central Bank, Federal Reserve Board 4

5 First consequence, reserve balances soared 1400 $ Billions Source: Federal Reserve 5

6 As reserves expanded, the Fed found it increasingly difficult to achieve the target for the funds rate using the Traditional operating Framework 6 Percent Source: Federal Reserve 0 6

7 Second consequence, equity decreased: the way we were. Federal Reserve Balance Sheet Breakdown as of 3/1/2007 Assets Liabilities + equity Treasuries 94% Currency 87% Repos 5% Banks reserves 3% Other assets 1% Reverse repos 4% Other liabilities 2% Equity 4% 7

8 The way we are Federal Reserve Balance Sheet Breakdown as of 4/6/2016 Assets Liabilities + equity Treasuries 54% Currency 32% Agencies + MBS 40% Banks reserves 52% Other assets 6% Reverse repos 8% Other liabilities 7% Equity <1% 8

9 Structure of talk First, we will talk about how the fed has adapted to its framework to be able to do BOTH monetary and liquidity policy. We will describe the traditional framework Explain why stopped working when reserves increased Describe the new framework Interest rate corridor International experience Second, we will talk about the consequences of reduction on equity. We will talk about the risk for inflation International experience 9

10 The Traditional Operating Framework The demand for reserves slopes downward. Why? As FFR increase less demand for excess reserves (opportunity cost) FFR D Reserves 10

11 The Traditional Operating Framework The FOMC sets a target for the federal funds rate that is consistent with its goals for economic activity and inflation. FFR FFR* D Reserves 11

12 The Traditional Operating Framework The Open Market Desk at the New York Fed estimates the supply of reserves required to achieve the target funds rate. Supply of reserves are a tool ONLY for monetary policy (set FFR). FFR S FFR* R* D Reserves 12

13 The Traditional Operating Framework If we expand Balance Sheet (increase in reserves) because of liquidity policy. Is it possible to maintain FFR? The answer is NO. FFR S FFR* R* D Reserves 13

14 The New Framework: Monetary Policy Implementation Using an Interest Rate Corridor The Fed unconventional policies in the wake of the financial crisis greatly increased the size of its balance sheet for liquidity policy. Under the traditional framework the Fed lost control of monetary policy (no control over FFR) Interest rate corridor The interest rate on reserves as a floor under the federal funds rate. The discount rate limits any upward pressure on the funds rate.

15 The Corridor Operating Framework Target rate set at the midpoint of a range determined by the discount rate at the ceiling and interest on reserves at the floor. Potentially allows for greater control over the interest rate target. Allows the balance sheet to act as an independent instrument of liquidity policy. FFR at a midpoint of a range determined by the discount rate at the ceiling and interest on reserves at the floor. Potentially allows for greater control over the interest rate target. Allows the balance sheet to act as an independent instrument of liquidity policy. 15

16 The Corridor Operating Framework The demand for reserves depends on the discount rate and the interest rate on reserves. FFR Discount Rate IOR D Reserves 16

17 Traditional + Corridor Operating Framework The corridor limits fluctuations in the federal funds rate: Low volatility. This is important, since Risk Matters for Latin America. Fernandez-Villaverde, Guerron-Quintana, Rubio-Ramirez (2011). This is a good thing and that it is why it has been implemented by many central banks even before crisis. FFR S Discount Rate FFR* IOR D R* Reserves 17

18 Liquidity Policy The interest rate floor allows monetary policy to be divorced from liquidity policy. FFR S S' Discount Rate FFR* FFR*' = IOR D R* R*' Reserves 18

19 "Exit Strategy" The target interest rate can be raised without reducing the supply of reserves. FFR S Discount Rate 2 FFR 2 *= IOR 2 D 2 Discount Rate 1 FFR 1 * =IOR 1 D 1 R Reserves 19

20 Will the soft floor limit the effectiveness of interest on reserves as a policy tool? The funds rate may continue to trade somewhat below the interest rate on reserves, but should move up in lock step with increases in the interest rate on reserves. In addition, the Fed can drain reserves through various temporary operations or through outright asset sales to help provide additional support under the funds rate target. 20

21 The European Central Bank s Corridor System The ECB s corridor system became operative with the launch of the Euro in The corridor floor is the rate on overnight deposits with national central banks. The ceiling is the ECB marginal lending facility. Policymakers set both the target for the overnight rate and the width of the corridor at monetary policy meetings. The size of the corridor has varied over time; currently, it is 150 basis points wide.

22 The European Central Bank s Corridor System Main Refinancing Operations Euro Overnight Index Average Rate Marginal Lending Facility rate Deposit Facility Rate Source: European Central Bank

23 The Swedish Riksbank s Corridor System The Riksbankadopted a corridor in June 1994 after eliminating reserve requirements at banks. Originally, the width of the corridor was set separately from the target rate and was used to signal the monetary policy stance. The corridor floor is the deposit rate offered by the Riksbank. The ceiling is the Riksbank s lending rate. After December 2000, the width of the corridor was no longer an instrument of monetary policy and was fixed at 150 basis points. It was narrowed during the crisis but has since been restored. From July 2009 to September 2010, the corridor floor was negative. Banks continued to hold deposits at the central bank despite the disincentives to hold balances at a negative interest rate.

24 The Swedish Riksbank s Corridor System Stockholm Interbank Offered Rate Lending Rate Deposit Rate Source: Sveriges Riksbank -2.00

25 Consequences of Reduction on Equity Large balance sheet can have consequences for inflation. If Treasury is ready to cover the central bank s losses no problem. In absence of treasury s support, large central bank losses can only be resolved through a prolonged increase in inflation. Why? Seigniorage source of profits. Some research on issue Bassettoand Phelan (2015), Del Negro and Sims (2015), Hall and Reis (2015), Benignoand Nistico(2015), and Corsettiand Dedola(2015). International experience: Bank of England QE profits/losses accrue to UK Treasury. This solves the problem is large reduction on equity. Would the fed do it? It does not seem possible. 25

26 Conclusions With interest now paid on reserves, the Fed now has in place the basic elements of a corridor operation system. Interest on reserves will play an important role when the Fed begins to exit from its highly accommodative policy stance. Floor of Corridor. Other central banks adopted corridor systems in the 1990s. The corridor system allows monetary policy to be divorced from liquidity policy and also the corridor system decreases volatility. But the loss of control over monetary policy is not the only consequence of expansionary. Reducing on equity another consequence that may increase inflation. Solution: insurance from Treasury (U.K. has done it) 26

Chapter Eighteen 4/23/2018. Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 4. Unconventional Policy Tools

Chapter Eighteen 4/23/2018. Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 4. Unconventional Policy Tools Chapter Eighteen Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 4 Unconventional Policy Tools Using non-traditional policy tools for stabilization : When lowering the target interest-rate