BY: DALAL ALARBEED Effective Monetary Policy in a Low Interest Rate Environment

James Bullard The president and chief executive officer of the Federal Reserve Bank of St. Louis. (position he has held since 2008) He participates in the Federal Open Market Committee (FOMC). He called for the FOMC to adopt state- contingent policy, which is policy that is adjusted based on the state of the economy.

Mr. Bullard discussed his vision for a shift in monetary approach similar to the one brought to the world by Paul Volcker in Mr. Bullard argued that a shift was necessary and that the era of interest rate rules is in abeyance Introduction

The End of Interest Rate Rules In December 2008, the Policy rates of most Central Banks were at historically low levels:  Federal funds rate: 0.00 – 0.25%  Benchmark rate of the European Central Bank: 1.5%  Bank of England: 0.5%  Bank of Japan: 0.1% Thus, with policy rates at or near zero, it would seem that the World’s central banks have little or no scope for further policy response.

So … What to do? Keeping stabilization policy active and aggressive in the current global recession requires a shift in thinking. A shift away from a focus on short-term nominal interest rates and toward quantitative approaches is more appropriate, at least for now.

Monetary Growth and Expected Inflation At very low nominal interest rates, the expected rate of inflation plays a larger role. Declines in the expected rate of inflation, with nominal rates fixed, show up as increases in the real rate of interest. real interest rate = nominal interest rate - expected inflation One key to current stabilization policy is therefore to influence the expected rate of inflation.

Monetary Policy with an ‘M’ Conventional monetary policy has been known as a central bank establishing an effective target for a short-term nominal interest rate. However, with policy rates at or near zero, nominal interest rate targeting is no longer an option. Thus, central banks lose their ability to use interest rate movements to signal their policy moves to the public. This creates uncertainty in the economy

Monetary Policy with an ‘M’ One way of providing a credible nominal anchor for the economy is to set quantitative targets for monetary policy, beginning with the growth rate of the monetary base. However, the lack of precision may stand in the way of determining how rapidly to expand the base. Persistent monetary growth can prevent further disinflation and rise real interest rates even while further reductions in the nominal interest rate are no longer possible.

Persistent Vs. Temporary Growth in the Monetary Base MB = CC + Deposits Increases in the monetary base are either: TypeTemporaryPersistent Influence on the rate of inflation NoYes The increase is associated with: Lender-of-last-resort programs Treasury securities Mortgage-backed securities Agency debt

Persistent Vs. Temporary Growth in the Monetary Base In the US, the size of the monetary base doubled over a four-month period beginning in September However, the increase in the base is in part a byproduct of Federal Reserve programs to assist credit markets and carry out its lender-of-last-resort function. (Temporary) The persistent components are likely to have greater inflationary consequences going forward because these components are unlikely to shrink as much or as quickly as the others.

A Clear Inflation Objective Uncertainty and the implications for inflation could be reduced with the announcement of a specific inflation objective. A credible plan would also name an explicit inflation objective to help control the currently very diffuse expectations of medium-term inflation. By making the long-run inflation objective explicit, the Fed could help provide a credible commitment that the growth of the monetary base will slow as deflation risks draw back. Moreover, it would reduce inflation risk premiums in interest rates and promote efficient resource allocation.

The Future of Financial Intermediation Maintaining price stability is surely one of the most important ways that a central bank can promote the stability of the financial system. The ongoing financial crisis demonstrates, however, that price stability alone will not guarantee financial stability. The crisis has revealed important problems in our system of financial regulation and oversight.

The Future of Financial Intermediation Present system was not designed to control broad macro- economic risks posed by large and complex financial organizations with global operations. The governments are unlikely to permit such firms to fail, which creates a “too-big-to-fail” problem. Thus, it creates a moral hazard: Firms whose liabilities are guaranteed have an incentive to take greater risks. It also creates uncertainty because it leaves the nature of the intervention in the event of failure unspecified.

The Future of Financial Intermediation There is a need for improvement in the current system. The improvement would be to design a resolution regime with the following features:  it should be explicit and well understood by all players.  the nature of government assistance should be clear.  it should be credible!!  it should be made clear which firms would use this alternative resolution regime and which firms would use bankruptcy court.

Conclusion The financial crisis has challenged our thinking about both monetary policy and financial regulation. A shift away from interest rate rules and toward quantitative approaches is crucial. We need a clearly stated, credible policy which indicates how the central bank plans to respond to macroeconomic events. The crisis has clearly exposed faults in the structure of financial regulation and supervision.

THANK YOU !!!!