Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 1 Chapter Eighteen Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 1

Develop understanding of Fed and ECB conventional policy tools. How policy tools link to instruments link to goals. Simple guides for policy setting. Unconventional policy tools.

The Fed can control the MB but cannot precisely control the Money Supply M1 = m x MB 1+(C/D) M1 =  MB rD + (ER/D) + (C/D) Households can change C/D, causing the money multiplier (m) and M1 to change. Banks can change ER/D, causing m and M1 to change.

The Fed’s “Traditional” Policy Tools Open Market Operations - OMO. Discount Rate - the interest rate the Fed charges on the loans it makes to banks Reserve Requirement - the level of balances a bank is required to hold either as vault cash on deposit or at a Federal Reserve Bank NOTE: The primary instrument of monetary policy is the Federal funds rate: the interest rate on overnight loans of reserves from one bank to another

A New (fourth) Tool Interest on Reserves - required and excess Currently set at 1.25% since June 2017. Often referred to as IOER – Interest on Excess Reserves – but currently applies to all reserves. Cecchetti refers to this as the Deposit Rate The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to begin paying interest on reserve balances of depository institutions beginning October 1, 2011.  The Emergency Economic Stabilization Act of 2008 accelerated date to October 1, 2008. 

More New Tools Term Deposit Facility ON RRP http://www.federalreserve.gov/monetarypolicy/policytools.htm

Open Market Operations The Fed buys and sells U.S. (Gov’t) securities in the secondary market in order to adjust the supply of reserves in the banking system. Traditionally _________. This changed with ___________. Fed has purchased ___________________. Most flexible means of carrying out monetary policy. With OMO the Fed does not participate directly in the Federal Funds market. The Fed does not want the credit risk associated with direct participation.

Open Market Operations The Fed buys and sells U.S. (Gov’t) securities in the secondary market in order to adjust the supply of reserves in the banking system. Traditionally short-term T-bills. This changed with “quantitative easing”. Fed has purchased long-term T-bonds and MBS. OMO is the most flexible means of carrying out monetary policy. With OMO the Fed does not participate directly in the Federal Funds market. The Fed does not want the credit risk associated with direct participation.

OMO and the Federal Funds Market Federal funds are reserve balances that depository institutions lend to one another. The most common transaction is an overnight, unsecured loan between two banks. (bilateral agreements) Note that without the FF market, banks would need to hold a substantial amount of excess reserves.

Advantages of OMO Implemented quickly Fed has complete control Flexible and precise Easily reversed

Two Types of Open Market Operations Permanent OMOs: “involve the buying and selling of securities outright to permanently add or drain reserves available to the banking system.” Temporary OMOs: “involve repurchase and reverse repurchase agreements that are designed to temporarily add or drain reserves available to the banking system” https://www.newyorkfed.org/markets

Open Market Operation - Repo With a repurchase agreement ("repo"), the Fed buys securities from dealers who agree to buy them back, typically within one to fifteen days. Repo adds reserves to the banking system and then withdraws them. Can be viewed as the Fed temporarily lending reserves to dealers with the dealers posting securities as collateral.

Open Market Operation – Reverse Repo The Fed ______ securities to dealers and dealer agrees to ___them back to the Fed. ______reserves and later adds them back. Can be viewed as the Fed temporarily borrowing reserves from dealers with the Fed posting securities as collateral. Also called a “matched-sale purchase transaction”.

Open Market Operation – Reverse Repo The Fed sells securities to dealers and dealer agrees to sell them back to the Fed. Drains reserves and later adds them back. Can be viewed as the Fed temporarily borrowing reserves from dealers with the Fed posting securities as collateral. Also called a “matched-sale purchase transaction”. https://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab9c

OMO Sale - Fed Balance Sheet Permanent RRP Securities: -$100 Reserves: -$100 Reserves: -$100 RRP: +$100

Open Market Operation – Reverse Repo Traditional use of REPO is to offer fixed quantity and let i adjust. Fixed Rate Over Night Reverse Repurchase Agreement (“ON RRP”) is different. The Fed will state the interest rate (fix i) and let quantity adjust.

OMO Counterparties Primary Dealers https://www.newyorkfed.org/markets/primarydealers ONRRP Counterparties https://www.newyorkfed.org/markets/rrp_counterparties

Monetary Policy rate, rate, and rate. There are three interest rates the Fed “controls”: rate, rate, and rate.

Monetary Policy The federal funds rate, The discount rate, and There are three interest rates the Fed “controls”: The federal funds rate, The discount rate, and The deposit rate (interest on reserves).

Monetary Policy The federal funds rate is the primary instrument of monetary policy. Referred to as the policy rate. In the past monetary aggregates such as the monetary base or the money supply were use as the instruments on monetary policy. Tools are used to affect instruments which in turn affect the goals of the central bank - maybe.

Monetary Policy Between September 2007 and December 2008, the FOMC lowered its target for the federal funds rate 10 times from around 6% to zero. This was the first time since the 1930s that the Fed hit the zero bound on the nominal federal funds rate.

The Target Federal Fund Rate

Monetary Policy Lowering the federal fund rate at zero wasn’t enough to stabilize the economy. The crisis had undermined the willingness and ability of major financial intermediaries to lend. In this environment the Fed moved to substitute itself for dysfunctional intermediaries and markets. This significantly altered the Fed’s balance sheet.

Monetary Policy Policymakers started to use __________ including: Massive purchases of risky assets in thin, fragile markets, and Communicating its intent to keep interest rates low over an extended period- “_________” In a financial crisis, central banks may also adjust the size and composition of their balance sheet – “quantitative easing”

Monetary Policy Policymakers started to use unconventional policy tools including: Massive purchases of risky assets in thin, fragile markets, and Communicating its intent to keep interest rates low over an extended period- “forward guidance” In a financial crisis, central banks may also adjust the size and composition of their balance sheet – “quantitative easing”

The Federal Funds Market Instead of fixing the interest rate, the Fed traditionally controls the federal funds rate by manipulating the quantity of reserves. The Fed does this by using open market operations.