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 to zero is not sufficient to stimulate the economy 2008 to 2016. Unconventional Policy Tools There are three categories of unconventional policy approaches: 1. Forward guidance This is when the central bank communicates intentions regarding the future path of monetary policy. 2. Quantitative easing (QE) When the central bank supplies aggregate reserves beyond the quantity needed to lower the policy rate to zero. 1
Unconventional Policy Tools 3. Targeted asset purchases (TAP) When the central bank alters the mix of assets it holds on its balance sheet in order to change their relative prices in a way that stimulates economic activity e.g. buying mortgages. When the Fed refers to its unconventional policy of large-scale asset purchases, the purchases are TAP, QE, or both Unconventional Actions Taken During Financial Crisis Lender of Last Resort Market Maker of Last Resort A simple unconventional approach talk. The Fed states intent to keep the policy target rate low for an extended period of time. Could have a specific termination date or duration or could be dependent on future change in economic conditions - Next 6 months Foreseeable future Unemployment rate comes down to 6.5% Did this via FOMC statements 2
Talk long-term rates down by convincing the public of the intent to keep ST rates low for an extended period of time - think term structure. To be effective, forward guidance needs to be credible. If not, markets may not respond as the central bank hopes. Between 2002 and 2004, the FOMC issued an unconditional commitment indicating that its target funds rate would stay low for the foreseeable future or for a considerable period. In 2004, it assured markets that the withdrawal of accommodation would occur at a measured pace to avoid fears of sharp rate hikes. In 2008, the FOMC adopted a conditional approach as the financial crisis deepened. weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. At one point stated funds rate would stay low until unemployment reduced to 6.5% 3
QE occurs when the central bank expands the supply of reserves beyond the level that would be needed to maintain its policy rate target. The central bank buys assets, thereby expanding its overall balance sheet. At a market federal funds rate equal to the interest on reserves, an addition to aggregate reserves no longer reduces the funds rate The Fed can add limitlessly to reserves without affecting the market federal funds rate. S 2014 Fed policymakers argue their balance sheet expansion helped to lower long-term interest rates, but there is disagreement on the impacts. An increase in the supply of reserves (QE) may simply lead banks to hold more of them rather than provide additional loans. 4
QE may reinforce the impact of forward guidance by adding credibility to policymaker s promise to keep interest rates low Announcements of an expansion of aggregate reserves (QE) could lower bond yields by extending the time horizon over which bondholders expect a zero policy rate. Targeted Asset Purchases Targeted asset purchases (TAP) change the composition of the balance sheet toward selected assets in order to boost their relative price, lower selected interest rates and stimulate economic activity. Targeted Asset Purchases Additionally, in the absence of private demand for the risky asset, the central bank s purchase makes credit available where none existed. Purchase relatively illiquid assets Fed purchase of MBS. 5
Targeted Asset Purchases Fed purchased over $1 trillion in MBS and more than $1.3 trillion in long-term Treasury debt Goal was to lower yields on mortgages and other long term bonds. In normal time a central bank typically avoids such direct allocation of credit. They promote competition rather than picking winners. Making an Effective Exit QE and TAP assets are typically more difficult to sell. A Fed may be unable to sell assets and withdraw reserves from the banking system fast enough to increase the policy rate when it desires. However, the Fed has several policy options that allow them to tighten (increase target FFR) without having to sell assets. Making an Effective Exit Raise the Deposit Rate The deposit rate sets the floor for the market federal fund rate. 6
Making an Effective Exit Paying interest on reserves allows the Fed to use two powerful policy tools independently of one another: 1. It can adjust the target FFR for interbank loans without changing the size or composition of its balance sheet, and 2. It can adjust the size and composition of its balance sheet without changing the target interest rate for interbank loans. The Fed can avoid a fire sale by simply raising the deposit rate that they pay on reserves. FFR Not at the Floor Fixed Rate ON RRP 7