5.9 financial markets and central bank online test
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Week9pp.pptxWeek 9 Topic: Monetary policy 2 Chapter of main text: Stephen Cecchetti and Kermit Schoenholtz
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Learning Objectives
Explain the conventional policy tools used by major central banks.
Discuss the links between monetary policy tools and objectives.
Use a simple guide to analyze monetary policy.
Describe unconventional monetary policy tools and how they work.
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Inflation Targeting
Inflation targeting focuses on the objective of low and stable inflation
It is a monetary policy strategy that involves public announcement of a numerical inflation target and underscores the central bank’s commitment to price stability.
When the target is credible, inflation will be low
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Inflation Targeting
Long-term expectations of low inflation act to anchor low long-term interest rates and promote economic growth.
Hierarchical mandate in which price stability comes first and everything else comes second
The ECB, Australia, Chile, South Africa, United Kingdom, and dozens of other countries
Dual mandate in which the goal of price stability and maximum employment are equal
The Fed
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Inflation Targeting
Increases policymakers accountability and helps establish their credibility
Helps overcome the time-consistency problem
The result is not just lower and more stable inflation, but usually higher and more stable economic growth
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Should central banks aim to control inflation, the price level, or nominal GDP?
Proponents of price-level, or nominal GDP targeting argue that policymakers gain the ability to raise expected inflation by more than inflation targeting would
This would drive the real interest rate further down and stimulate economic expansion
Advocates view this approach as more effective than quantitative easing at the effective lower bound
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A Guide to Central Bank Interest Rates: The Taylor Rule
Policymakers both pick a specific target and choose when to implement it.
The Taylor Rule tracks the actual behavior of the target federal funds rate and relates it to the real interest rate, inflation, and output.
Target fed funds rate =
Natural rate of interest + Current inflation + ½ (Inflation gap) + ½ (Output gap)
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A Guide to Central Bank Interest Rates: The Taylor Rule
The natural rate of interest is the real short-term interest rate that prevails when the economy is using resources normally.
Taylor originally used 2 percent, which is close to the average real short-term rate
The inflation gap is current inflation minus an inflation target (both measured as percentages)
When inflation exceeds the target level, the inflation gap is positive
The output gap is the percentage deviation of current output (real GDP) from potential output
When current output is above potential output, the output gap is positive
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A Guide to Central Bank Interest Rates: The Taylor Rule
When inflation rises above its target level,
The response is to raise interest rates.
When output falls below the target level,
The response is to lower interest rates.
If inflation is currently on target and there is no output gap,
The target federal funds rate should be set at the natural rate of interest plus target inflation.
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A Guide to Central Bank Interest Rates: The Taylor Rule
The Taylor rule has some interesting properties.
The increase in current inflation feeds one for one into the target federal funds rate; however,
The increase in the inflation cap is halved.
A 1 percentage point increase in the inflation rate raises the target federal funds rate 1½ percentage points.
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A Guide to Central Bank Interest Rates: The Taylor Rule
The Taylor rule tells us that for each percentage point increase in inflation,
The real interest rate, equal to the nominal interest rate minus expected inflation, goes up half a percentage point.
This means that higher inflation leads policymakers to raise the inflation-adjusted cost of borrowing.
This then slows the economy and ultimately reduces inflation.
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A Guide to Central Bank Interest Rates: The Taylor Rule
The Taylor rule also states that for each percentage point output is above potential:
Interest rates will go up half a percentage point
The halves in the equation depend on both:
How sensitive the economy is to interest-rate changes and the preferences of central bankers.
The more bankers care about inflation:
The bigger the multiplier for the inflation gap, and the lower the multiplier for the output gap.
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A Guide to Central Bank Interest Rates: The Taylor Rule
The implementation of the Taylor rule requires four inputs:
The natural rate of interest
A measure of inflation
A measure of the inflation gap
A measure of the output gap
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A Guide to Central Bank Interest Rates: The Taylor Rule
Economists and central bankers believe that the personal consumption expenditure (PCE) index is a more accurate measure of inflation.
Using the Fed’s inflation target of 2% and assuming the natural rate of interest is 2%, the neutral target federal funds rate is 4 percent = (2 + 2).
For the output gap, the usual choice is the percentage by which GDP deviates from a measure of its trend, or potential.
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A Guide to Central Bank Interest Rates: The Taylor Rule
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A Guide to Central Bank Interest Rates: The Taylor Rule
We should recognize some caveats.
At times the target rate does deviate from the Taylor rule.
It is too simple to take account of sudden threats to financial stability.
The federal funds rate will be below the Taylor rule in periods characterized by at least one of two factors:
Unusually stringent conditions across an array of financial markets
Deflationary worries that arose as nominal interest rates approached zero
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A Guide to Central Bank Interest Rates: The Taylor Rule
When financial conditions are much stronger, or weaker than usual policymakers seeking to stabilize the economy may set an interest-rate target that differs substantially from the Taylor rule
Alter prospects for private spending and inflation
Uncertainty about the natural rate of interest
There is a lack of real time data.
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GDP figures suffer from three problems that make initial figures less accurate:
Timeliness—the first estimate of GDP takes about a month to calculate after the end of a quarter.
Seasonality—GDP varies by season.
Revisions—revisions occur constantly.
Quarterly changes in GDP are very noisy.
Other guides to economic performance may be more useful.
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Unconventional Policy Tools
Most central banks set a target for the overnight interbank lending rate.
However there are two circumstances when additional policy tools can play a useful stabilization role:
When lowering the target interest-rate to zero is not sufficient to stimulate the economy
When an impaired financial system prevents conventional interest-rate policy from supporting economic growth
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Unconventional Policy Tools
There are three categories of unconventional policy approaches:
Forward guidance
This is when the central bank communicates intentions regarding the future path of monetary policy.
Quantitative easing (QE)
When the central bank supplies aggregate reserves beyond the quantity needed to lower the policy rate to its target (usually zero or lower).
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Unconventional Policy Tools
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.
When the Fed refers to its unconventional policy of large-scale asset purchases, the purchases are QE, TAP, or both
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The Fed officially recognizes several other unconventional tools, or facilities, which are described in Table 18.2.
Note that Table 18.2 leaves out several important mechanisms that the Fed used extensively in the crisis, and thereafter.
For example, it purchased more than $1 trillion of mortgage-backed securities.
The Fed also expressed its intent to keep the federal funds rate low for an extended period in order to influence long-term interest rate expectations.
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Forward Guidance
The simplest unconventional approach is for the central bank to provide forward guidance- guidance today about policy target rates in the future
They might express the intent to keep the policy target low for an extended period of time.
This could have a specific termination date, or duration could be dependent on some future change in economic conditions.
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Forward Guidance
To stimulate economic activity, forward guidance aims at lowering the long-term interest rates that affect private spending.
To be effective, forward guidance needs to be credible and time consistent
The Fed has used forward guidance with increasing frequency and refinement
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Forward Guidance
Although forward guidance can be effective, it is difficult to anticipate and reach consensus on the desirable policy path and to communicate these policy intentions simply
The potential for disturbing side effects, including asset price bubbles
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Quantitative Easing
QE occurs when the central bank expands the supply of aggregate 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 excess 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.
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Quantitative Easing
It is difficult to predict the effects of QE.
Fed policymakers argue their balance sheet expansion helped to lower long-term interest rates, but there is disagreement on the impacts.
The mechanism by which QE affects economic prospects is not clear.
An increase in the supply of reserves (QE) may simply lead banks to hold more of them rather than provide additional loans.
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Quantitative Easing
One mechanism is that QE can add credibility to a 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.
QE may reinforce the impact of forward guidance
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Quantitative Easing
A problem with QE is that central banks do not know now much is needed to be effective.
QE can be powerful tool for central bankers to prevent a sustained deflation, especially when conventional policy tools have been exhausted.
The first and largest application since the Great Depression occurred immediately after the Lehman failure in September 2008 (QE1).
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Targeted Asset Purchases
Targeted asset purchases (TAP) shift the composition of the balance sheet toward selected assets in order to boost their relative price and stimulate economic activity.
The central bank’s actions can influence both the cost and availability of credit.
In the absence of private demand for the risky asset, the central bank’s purchase makes credit available where none existed.
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Targeted Asset Purchases
The impact of TAP is likely
To be greater in thin, illiquid markets.
To be larger the bigger the difference between the yield on the asset that the central bank buys and the yield on the asset that the central bank sells.
By altering the relative supply of such assets to private investors, TAP narrows their interest rate differences.
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Targeted Asset Purchases
In buying more than $1.8 trillion in MBS and more than $2 trillion in long-term Treasury debt, the central bank’s goal was to lower yields on mortgages and other long term bonds.
A central bank cannot reliably anticipate the impact of TAP on the cost of credit.
In normal time a central bank typically avoids such direct allocation of credit.
They promote competition rather than picking winners.
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Targeted Asset Purchases
TAP purposely deviates from such asset neutrality in order to influence relative prices.
Exiting from TAP is probably also more difficult than unwinding QE.
TAP assets are generally harder to sell than short-term Treasuries.
The central bank may not be able to get rid of them exactly when it wants.
Political influences can become important if the Fed is hindered from selling specific assets for fear of raising the costs of a particular class of borrowers.
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Why 2% inflation rate?
A target of 0% inflation would require policy to continually flirt with deflation, which conventional policy tools are ill-suited to address.
Inflation is commonly overstated by 1%
The proper level of the policy interest rate is the sum of: the neutral real interest rate, the inflation target, one-half of the difference between current inflation and the inflation target, and -1 times the unemployment gap (difference between the current unemployment rate and natural rate of unemployment)
Raising the target inflation rate is not likely, even though policymakers might wish they had initially chosen a higher rate of inflation
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Making an Effective Exit
When central banks pursue conventional interest-rate targets, officials think about the policy choices they face every six to eight weeks.
The introduction of and exit from unconventional policies also require looking in to the future.
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Making an Effective Exit
What happens when QE and TAP have vastly expanded the amount of reserves and assets on the central bank’s balance sheet?
The central bank may need to sell a large volume of assets to reduce reserve supply sufficiently to raise the policy rate target.
But, QE and TAP assets are typically more difficult to sell.
A central bank may be unable to sell assets and withdraw reserves from the banking system rapidly enough to hike the policy interest rate when it desires.
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Making an Effective Exit
Central banks have several policy options that allow them to raise interest rates without reducing the level of reserve supply or changing the composition of the balance sheet.
To tighten policy, the Fed raises the IOER rate
Paying interest on reserves allows a central bank to control both price and quantity:
Price: It can adjust the target short-term interest rate (or range) and IOER rate without changing the size or composition of its balance sheet
Quantity: It can adjust the size and composition of its balance sheet without changing the target short-term rate or IOER rate
This means the central bank can change its balance sheet in a fashion consistent with financial stability while keeping inflation under control.
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Prudential tools, both micro and macro (including stress tests) should remain the first line of defenses against financial stability
Monetary policy can create financial stability risks, changing the path of policy in specific cases to reduce these risks is difficult to justify
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