Module 8
Monetary Policy and Stabilization Assignment
a. The Federal Reserve’s Conventional Policy Toolbox
Like all central banks, the Federal Reserve can alter the quantity of reserves
that depository institutions hold. Reserves are injected into the banking system
through an increase in the size of the Fed’s balance sheet, either because of a decision
by the Fed to buy securities or because of a bank’s decision to borrow from the Fed.
Besides controlling the quantity of reserves, the central bank can control either the
size of the monetary base or the price of its components. (We will revisit these control
options when discussing the$role of interest paid on excess reserves.) Like most
modern central banks, the Fed usually sets policy by focusing its attention on prices,
rather than quantities. The prices it concentrates on are the interest rate at which banks
borrow and lend reserves overnight and the interest rate that the Fed pays on reserves
that banks hold at the central bank.3 Understanding day-to-day monetary policy
requires a familiarity with the institutional structure of the central bank and financial
markets. What is true in one country may or may not be true elsewhere. Because
cataloging the structure and tools of monetary policy around the world is too big a
task, we will begin with the Federal Reserve and financial markets in the United
States. In the next section, we will look at the ECB’s operating procedures to see how
they differ.
Before we examine these four tools in detail, it is worth noting that the target
for the Fed could change in the next few years. In recent years collateralized lending,
such as repurchase agreements, has virtually replaced uncollateralized lending, which
forms the basis for the federal funds rate. Private organizations have developed
various secured short-term reference rates as alternatives to the federal funds rate. The
Fed is exploring whether to shift its day-to-day interest rate instrument to one of these
new benchmarks. While such a shift is unlikely to have broad macroeconomic
implications, it will alter the details of Fed operations.
Prior to the financial crisis, the target federal funds rate was the Federal Open
Market Committee’s primary policy instrument. Financial market participants
constantly speculated about movements in this rate. FOMC meetings always ended
with a decision on the target level, and the statement released after the meeting began
with an announcement of that decision. To a large extent, that decision constituted
U.S. monetary policy. But because the federal funds rate was, and remains, the rate at
which banks borrow from other financial intermediaries overnight, it is determined in
the market, not controlled by the Fed. With this qualification in mind, we distinguish
between the target federal funds rate set by the FOMC and the market federal funds
rate, at which transactions between banks and their overnight lenders take place.
The name federal funds refers to the fact that the funds are the reserve
balances held by banks at the Federal Reserve Banks. For many years before the
September 2008 failure of Lehman Brothers, aggregate reserves were scarce—on the
order of $10 billion—and excess reserves were less than $2 billion. As a result, banks
economized on their reserve holdings. Day-to-day discrepancies between actual and
desired reserves gave rise to a market for reserves, with some banks lending out their
excess and others borrowing to cover a shortfall in their required balance. Without this
market, banks would have needed to hold substantial quantities of excess reserves as
insurance against shortfalls. Because the loans are unsecured—there is no collateral to
fall back on in the event of nonpayment—the borrowing bank must be creditworthy in
the eyes of the lending bank, or the loan will not be made. As one would expect,
demand for reserves (banks’ deposits at the Fed) has always been negatively related to
the cost of holding them. And since one of the closest alternatives to holding reserves
has been an overnight loan to another bank at the market federal funds rate, this
interest rate remains a good proxy for the opportunity cost of holding reserves. The
Fed continues to be the monopoly supplier of aggregate bank reserves. On any
particular day, the Fed can choose the amount of reserves to supply, so that the supply
curve is vertical at that level. Until September 2008, the Fed faced the kind of
downward-sloping demand for its product that typically confronts a monopolist.
By buying or selling securities in the market through an open market operation
(OMO), the Fed could increase or decrease the supply of reserves (shifting the supply
curve to the right or the left) in order to lower or raise the market federal funds rate.
The use of OMOs in small volume—no more than a few billion dollars on any given
day—allowed the Fed to hit its federal funds target with reasonable accuracy. And if
the demand for reserves was unexpectedly high on a particular day, the Fed could lend
elastically at the discount rate (set at a spread above the federal funds target rate) to
prevent the market federal funds rate from rising too far. That was the state of affairs
up to the failure of Lehman Brothers in September 2008. But as the financial crisis
intensified in the fall of 2008, the Fed first lowered its policy target close to zero and
then, over the next five years or so, engaged in several rounds of large-scale asset
purchases (LSAPs) that boosted the supply of reserves far beyond the level needed to
keep the federal funds rate near zero depicts the scale of this quantitative easing (QE)
as the gap between the point where reserve demand becomes flat (point B) and the
point at which the reserve supply curve on the right intersects the near-zero IOER rate
(point C). By mid-2014, reserves had ballooned dramatically: Total reserves peaked at
$2.8 trillion, more than 300 times their 2007 average; and excess reserves were $2.7
trillion, over 1,400 times larger!
An additional change occurred at the height of the financial crisis: Beginning
in December 2008, policymakers began specifying a target range, instead of a target
level, for the federal funds rate. The range was initially set as 0.00 to 0.25 percent. It
was not until December 2015, when the Federal Open Market Committee began to
normalize monetary policy, that they raised this range, by 25 basis points (making it
0.25 to 0.50 percent). Initially, the IOER rate corresponded with the upper limit of the
target range, but as of mid-2019, it is set within the target range. This is the backdrop
of monetary policy today (2020) and probably in coming years. Reserves remain so
abundant that, unless the Fed is willing to sell hundreds of billions of dollars worth of
securities, it cannot get back to the point where small OMOs would have any impact
on the federal funds rate. Any attempt to operate within the precrisis framework faces
two insurmountable obstacles. First, given the introduction of interest on reserves in
October 2008, no one knows much about the demand for reserves, including the
location and the steepness of the line to the left of the kink. Second, sales of securities
on such a massive scale would lead to unpredictable and potentially serious
disruptions in financial markets.
So instead, the Fed has begun to employ a relatively new set of tools to tighten
monetary policy and drive up interest rates in financial markets. The principal device
is the IOER rate, at which banks would prefer to deposit at the Federal Reserve rather
than provide loans to other institutions. When the FOMC announces an increase in its
target range, the Fed implements the change by raising the IOER rate; it thereby raises
the minimum rate at which banks are willing to lend. No less important, a higher
IOER rate encourages banks to bid aggressively for funds from other money-market
participants in order to deposit them in their reserve accounts at the Fed’s riskless
IOER rate. So, when the Fed hikes the IOER rate, other short-term rates are dragged
upward by the banks’ actions. Graphically, raising the IOER rate raises the flat portion
of the reserve demand. This moves the equilibrium in the market for bank reserves
from point C to point D. So, the Fed sets monetary policy primarily by using the
IOER rate. Importantly, this interest rate tool allows the FOMC to raise interest rates
in the economy, thereby tightening financial conditions, without altering the supply of
reserves. In effect, the Fed has developed a clever way to independently set both the
price (the interest rate) and the quantity of the product (aggregate reserves) that it
supplies. Most monopolists have to choose one or the other.
From 2017 until August 2019, the Fed shrank its balance sheet. Going
forward, however, policymakers aim to ensure an abundant supply of reserves in
order to remain on the flat portion of the reserve demand curve. Consequently, in the
future, the balance sheet will expand to accommodate the demand for reserves, as
well as increases in the demand for non-reserve liabilities, such as currency and the
deposits of the federal government at the Fed.
When a central bank extends credit to commercial banks, its balance sheet
changes. So by controlling the quantity of loans it makes, a central bank can control
the size of reserves, the size of the monetary base, and ultimately interest rates. While
the Fed could take this approach (and did for the first decade of its existence in the
early 20th$century), today it does not. Lending by Federal Reserve Banks to
commercial banks, called discount lending, is usually small aside from crisis periods.
During a normal week, the entire Federal Reserve System makes at most a few
hundred million dollars in loans. Yet, discount lending is the Fed’s primary tool for
ensuring short-term financial stability, eliminating bank panics, and preventing the
sudden collapse of institutions that are experiencing financial difficulties. When there
is a crisis, discount lending explodes. On Wednesday, September 12, 2001, the first
business day after the collapse of the World Trade Center, banks borrowed $45.5
billion from the Fed! In the preceding week, borrowing had averaged just over $100
million per day. Similarly, in the weeks after Lehman failed in September 2008,
discount lending surged to $110$billion, while total borrowings of depository
institutions from the Fed approached $700$billion!
Recall that crises were the primary impetus for the creation of the Federal
Reserve in the first place. The idea was that some central government authority should
be capable of providing funds to sound banks to keep them from failing and sparking
a financial panic. The knowledge that the central bank would not allow solvent banks
to become illiquid—that depositors could always get their funds—became one of the
important safeguards against bank runs. The central bank, then, is the lender of last
resort, making loans to banks when no one else will or can. But a bank is supposed to
show that it is sound to get a loan in a crisis. This means having assets that the central
bank is willing to take as collateral, because the central bank does not make
uncollateralized loans.
A bank that does not have assets it can use as collateral for a discount loan is a
bank that should probably fail. Indeed, this is the principal reason that Fed officials
gave when they explained why they could not prevent Lehman’s failure in September
2008. For most of its history, the Federal Reserve loaned reserves to banks at a rate
below the target federal funds rate. Borrowing from the Fed was cheaper than
borrowing from another bank. Even so, no one borrowed, because the Fed required
banks to exhaust all other sources of funding before they applied for a loan.
Moreover, banks that used discount loans regularly faced the possibility of being
denied loans in the future. Needless to say, these practices created quite a disincentive
to borrow from the Fed. Almost everyone was willing to pay high rates in the
marketplace rather than ask the Fed for a loan; only banks with nowhere else to go
went to the Fed. But by severely discouraging banks from borrowing, the Fed created
volatility in the market for reserves. Eventually, officials decided to make the process
more rational. In 2002, they instituted the discount lending procedures that are in
place today.
Primary credit is extended on a very short-term basis, usually overnight, to
institutions that the Fed’s bank supervisors deem to be sound (as measured by the
standardized ratings they produce).6 Banks seeking to borrow must post acceptable
collateral to back the loan.7 The interest rate on primary credit is set at a spread above
the IOER rate. This is called the primary discount rate. 8 The term discount rate
usually refers to this primary discount rate. As long as a bank qualifies and is willing
to pay the penalty interest rate, it can get the loan. The rules allow a borrowing bank
to lend the funds again if it wishes. Primary$credit adds to the Fed’s supply of reserves
to the banks. When reserves were scarce—as they were prior to September 2008—
providing a facility through which banks could borrow at a penalty rate above the
target kept the market federal funds rate from rising above the discount rate. That’s
because, if it rose above, banks that would normally borrow in the federal funds
market could instead go to the discount window and borrow reserves from the Fed.
Secondary credit is available to institutions that are not sufficiently sound to
qualify for primary credit. Because secondary credit is provided to banks that are in
trouble, the secondary discount rate is set above the primary discount rate. There are
two reasons a bank might seek secondary credit. The first is the standard one: a
temporary shortfall in reserves. But short-run secondary borrowing is very unusual.
Banks that request secondary credit from the Fed are banks that can’t borrow from
anyone else. By offering to pay a rate above the primary discount rate, a bank signals
other banks that it doesn’t qualify for primary credit. By paying the Fed the secondary
discount rate for funds, the bank advertises that it is in trouble. It is hard to see any but
the most desperate banker doing this. Indeed, even during the crisis of 2007–2009,
secondary credit did not exceed $1 billion. So who is secondary credit for, anyway? It
is for banks that are experiencing longerterm problems that they need some time to
work out. There are times when banks have serious financial difficulties that they can
resolve without failing. A bank that takes a large loss from poor lending decisions will
become undercapitalized, but it may be able to raise funds to continue operating if it is
given enough time. Such a bank has nothing to lose by requesting secondary credit.
Without it, it will fail anyway. But before the Fed makes the loan, it has to believe
there is a good chance the bank will be able to survive. You can see why secondary
credit is rare.
Seasonal credit is used primarily by small agricultural banks in the Midwest to
help in managing the cyclical nature of farmers’ loans and deposits.9 Historically,
these banks had poor access to national money markets, so the Fed stepped in to
provide credit, charging them a market-based interest rate.10 In recent years,
however, there has been a move to eliminate seasonal credit. While the Fed still
extends more than $250 million of seasonal credit during the summer months, there
seems little justification for the practice any longer. Banks that used seasonal credit in
the past now have easy access to longer-term loans from large commercial banks.
Reserve requirements are an additional tool in the monetary policymaker’s
toolbox. Since 1935, the Federal Reserve Board has had the authority to set the
reserve requirements, the minimum level of reserves banks must hold either as vault
cash or on deposit at the Fed.11 Required reserves equal the required reserve ratio
times the level of deposits to which the requirement is applied changes in the reserve
requirement affect the money multiplier and the quantity of money and credit
circulating in the economy. Increasing it reduces the deposit expansion potential of
the banking system, lowering the level of money supported by a given monetary base.
So, by adjusting the reserve requirement, the central bank can influence economic
activity. For example, the People’s Bank of China often adjusts the reserve
requirement rate up or down in order to tighten or loosen bank credit supply. In the
United States, however, the reserve requirement turns out not to be very useful. One
reason is that small changes in the reserve requirement may have little impact when
the banking system is awash with reserves—keep in mind that required reserves have
been considerably less than 10 percent of total reserves since 2009. At the same time,
we cannot predict accurately how large changes in the requirement would affect the
level of deposits.
The case against using the reserve requirement as a direct policy tool also is
based on U.S. historical experience. Following the banking crises of the Great
Depression, U.S. banks began accumulating excess reserves. By the beginning of
1936, less than half of the $5.6$billion of reserves held in the banking system were
required; the rest were excess reserves. The Federal Reserve Board was puzzled and
became concerned that the high level of excess reserves could be used to support a
rapid expansion of deposits and loans, which would lead to inflation. To head off the
possibility, beginning in August 1936 the Fed used its newly acquired powers and in
three steps doubled the reserve requirement. Suddenly, $3 billion in excess reserves
was reduced to $1 billion. But the Fed had underestimated banks’ desire to hold
excess reserves to protect against the possibility of renewed bank runs. So, bank
executives spent the next year rebuilding their reserve balances until excess reserves
were back to the level where they had been before the reserve requirement was raised.
The consequences for the economy were grim. While the monetary base remained
relatively stable, the money multiplier plummeted, driving M1 and M2 down. As
monetary aggregates fell, the economy went along with them. From its peak in spring
1937 to its trough less than a year later, real GDP fell more than 10 percent.
b. Operational Policy at the European Central Bank
Like the Federal Reserve’s, the ECB’s monetary policy toolbox contains an
overnight interbank rate (equivalent to the federal funds rate), a rate at which the
central bank lends to commercial banks (equivalent to the discount rate), a reserve
deposit rate, (equivalent to the IOER rate), and a reserve requirement. While the
conventional toolkit is the same, the details are different, so let’s have a look at them.
Like the Federal Reserve, the ECB now frequently uses outright purchases of
securities to inject reserves into the banking systems of countries that use the euro.
But prior to 2012, it provided reserves primarily through collateralized loans in what
it calls refinancing operations. Originally, the main refinancing operation was a
weekly auction of repurchase agreements (repos) in which the ECB—through the 19
(as of 2020) national central banks (NCBs) of Eurosystem countries—provided
reserves to banks in exchange for securities, and then reversed the transaction up to
three weeks later. When reserves were scarce, the ECB’s usual policy instrument was
the minimum bid rate, set by the ECB’s Governing Council as the minimum interest
rate accepted at these refinancing auctions. The minimum bid rate is the ECB
equivalent of the Fed’s target federal funds rate, so we will refer to it as the target
refinancing rate. Now that reserves are plentiful, we will see that the effective
refinancing rate is determined by the ECB’s analog to the IOER rate, namely, the rate
offered by the ECB’s deposit facility.
Beginning in 2007, in an effort to steady financial markets, the ECB increased
the supply of reserves through longer-term refinancing operations (LTROs) at
maturities ranging from one month to one year. And to stabilize bank funding in late
2011 and early 2012—a period of intense financial turmoil in the euro area—the ECB
extended LTRO maturities to three years, a move that supplied more than €1 trillion to
banks. The financial turmoil also led the ECB to boost open market purchases of
securities, including the debt of euro-area sovereigns that had difficulties borrowing in
private markets. By early 2019, the ECB’s holdings of securities denominated in euros
accounted for over 60 percent of its €4.7 trillion in assets, while bank refinancing
operations (mostly LTROs) represented only 17 percent. With these changes, the
ECB’s operations have become more similar to the Fed’s. But there are still notable
differences.
The most important difference is that ECB operations are conducted
simultaneously at all the NCBs. The Fed’s open market operations are executed from
only one location, the Federal Reserve Bank of New York. And while the Fed solicits
prices from a short list of primary dealers (24 as of 2019) in the course of its normal
operations, hundreds of European banks participate in the ECB’s weekly auctions.
Finally, because of the differences in financial structure across euro-area countries, the
collateral that is accepted in refinancing operations differs from country to country.
Under normal circumstances, the Fed takes only U.S. government and agency
securities (although the range of accepted collateral widened during the crisis of
2007–2009).
In contrast to many central banks around the world, the European Central
Bank (ECB) and the National Central Banks (NCBs) of the euro area have a notably
inclusive approach to the range of assets they accept as collateral. This approach
encompasses tens of thousands of different marketable assets, offering a wide variety
that includes not only government bonds but also privately issued bonds and bank
loans. This extensive collateral framework is designed to support the liquidity needs
of financial institutions across the euro area, ensuring that they can continue to
operate smoothly and provide credit to the economy, even in times of financial stress.
The inclusiveness of the ECB’s collateral policy is particularly noteworthy
when considering the types of assets accepted. Privately issued bonds, which are debt
securities issued by corporations, are included in the pool of eligible collateral. These
bonds, often used by businesses to raise capital, can vary widely in terms of credit
quality and risk. By accepting them as collateral, the ECB provides a critical backstop
that helps maintain liquidity in the corporate bond market, encouraging investment
and economic activity.
Additionally, the ECB accepts bank loans as collateral, further broadening the
spectrum of eligible assets. These loans, which can include various types of
commercial and residential loans held by banks, are typically less liquid than
marketable securities. By including them in the collateral framework, the ECB
enhances the ability of banks to access central bank liquidity, thereby supporting
lending to households and businesses. This aspect of the collateral policy is
particularly important for smaller banks or those with significant loan portfolios, as it
allows them to leverage their existing assets to meet liquidity needs.
A particularly striking example of the ECB's inclusive collateral policy is its
treatment of Greek government debt during periods of severe financial distress. In
2012 and again in 2015, Greece was on the brink of default, facing unprecedented
financial turmoil and a severe crisis of confidence in its debt markets. Despite these
dire circumstances, the ECB continued to accept Greek government bonds as
collateral. This decision underscored the ECB’s commitment to maintaining financial
stability and supporting the Greek banking system during a time of intense economic
crisis.
By accepting Greek government debt as collateral, the ECB provided a crucial
lifeline to Greek banks, ensuring they could access the liquidity necessary to continue
operating and avoid a complete financial collapse. This move helped stabilize the
Greek financial system, preventing a broader contagion effect that could have spread
to other euro area countries and potentially threatened the stability of the entire
eurozone.
The ECB's willingness to accept such a wide range of collateral, including
high-risk assets during periods of crisis, reflects its broader mandate to ensure
financial stability across the euro area. This approach contrasts with more restrictive
collateral policies adopted by other central banks, which may only accept high-
quality, low-risk assets. The ECB’s inclusive policy aims to provide comprehensive
support to the banking sector, recognizing that financial institutions hold diverse
portfolios of assets that can be mobilized to meet liquidity needs.
Moreover, this policy is part of the ECB’s broader strategy to ensure the
smooth functioning of monetary policy transmission. By accepting a wide array of
collateral, the ECB enhances the ability of its monetary policy measures to reach all
parts of the euro area economy. This inclusiveness helps to mitigate fragmentation in
the euro area’s financial markets, ensuring that liquidity provided by the ECB can
flow effectively to banks and businesses in all member states, regardless of their
specific economic conditions.
In summary, the ECB and the NCBs of the euro area have adopted a notably
inclusive approach to the range of assets accepted as collateral. This extensive
framework, encompassing government bonds, privately issued bonds, and bank loans,
is designed to support financial stability and ensure the effective transmission of
monetary policy. The continued acceptance of Greek government debt during periods
of severe financial distress exemplifies the ECB’s commitment to this inclusive
policy, highlighting its role in maintaining stability and supporting the banking system
during times of crisis. This approach ensures that liquidity can flow throughout the
euro area economy, supporting growth and stability in both prosperous and
challenging times.
The ECB’s marginal lending facility is the analog to the Federal Reserve’s
primary credit facility. Through this facility, the ECB provides overnight loans to
banks at a rate that is normally well above the target refinancing rate. The spread
between the marginal lending rate and the target refinancing rate is set by the
Governing Council and was 25 basis points at the start of 2019. As in the case of
discount borrowing from the Fed, commercial banks initiate these borrowing
transactions when they face a reserve deficiency that they cannot satisfy more cheaply
in the marketplace. Banks do borrow regularly, and on occasion the amounts they
borrow are large. The similarity between this procedure and the Federal Reserve’s
primary credit facility is no accident, because the ECB’s system (which is itself based
on the German Bundesbank’s) was the model for the 2002 redesign of the Fed’s
discount window.
ECB’s deposit facility at an interest rate below the target refinancing rate. The
rate paid by the deposit facility is set by the ECB Governing Council; as of early
2019, it was 40 basis points below the target refinancing rate. Because a bank can
always deposit its excess reserves in the riskless deposit facility, it will never make a
loan at a lower rate. Therefore the deposit facility places a floor under the market
interest rate charged on loans made by banks. Once again, the ECB served as a model
for the Fed, which based the design of its IOER rate (introduced in October 2008) on
the ECB’s deposit facility.
Prior to the crisis, the deposit facility contained nearly all of the excess
reserves in the Eurosystem’s banks. Amounts were small, averaging €350 million or
so. In recent years, two developments have altered this pattern. First, the deposit
facility rate fell, hitting zero in mid-2012 before becoming negative two years later.
As a result, banks became indifferent between keeping their deposits in a “current
account” and shifting them into the deposit facility itself, as both paid the same
interest rate.13 Second, in 2014, the ECB began buying large quantities of sovereign
bonds as part of its quantitative easing policy. As a result, banks’ excess reserve levels
rose dramatically so that at the start of 2019 they stood at €1.9 trillion. It is interesting
to note that, even though the ECB charges a fee for accepting excess reserves—at the
beginning of 2019 the rate was –0.40 percent—banks did not switch from holding
reserves to holding cash in their vaults. Were they to make that switch, the policy
impact of the negative deposit rate would become contractionary rather than
expansionary.
The ECB requires that banks hold minimum reserves based on the level of
their liabilities. The reserve requirement of 1 percent is applied to deposits and debt
securities with a maturity of up to two years. The level of these liabilities is averaged
over a month, and reserve levels must be held over the following month. The
European system is designed to give the ECB tight control over the short-term money
market in the euro area. And it usually works well the target refinancing rate, which is
the minimum bid rate in the weekly auctions, as the red line running through the
center of the graph, with the marginal lending rate above and the deposit rate below
(both in blue). The overnight cash rate is the European analog to the market federal
funds rate, the rate banks charge each other for overnight loans. As you can see, this
rate fluctuates quite a bit. After the Lehman failure in 2008, it stayed below the target
refinancing rate for most of the period, as the ECB flooded the system with liquidity.
Yet, even in this period, the overnight cash rate remained within the band formed by
the marginal lending rate and the deposit rate.
Indeed, prior to the Federal Reserve's implementation of interest on reserves in
2008, the European Central Bank (ECB) had a track record of effectively managing
short-term interest rates to closely align with its policy targets. This success can be
attributed to several factors that distinguish the ECB's monetary policy framework
from that of the Federal Reserve and other central banks.
One key aspect of the ECB's approach is its focus on maintaining price
stability as the primary objective of monetary policy. Since its inception, the ECB has
been committed to achieving and maintaining inflation rates close to but below 2
percent over the medium term. This clear and specific mandate provides a strong
anchor for the ECB's policy decisions, guiding its actions to ensure that inflation
expectations remain well-anchored and that monetary policy remains predictable.
Another factor contributing to the ECB's success in managing short-term
interest rates is its operational framework for conducting monetary policy operations.
The ECB employs a system of "fixed-rate full allotment" in its main refinancing
operations, which allows banks to borrow funds from the central bank at a pre-
specified interest rate against eligible collateral. This operational framework provides
certainty and transparency to financial markets, helping to stabilize short-term interest
rates and maintain liquidity in the banking system.
Furthermore, the ECB's commitment to ensuring the smooth transmission of
monetary policy across the euro area contributes to its effectiveness in managing
interest rates. The euro area consists of diverse economies with varying economic
conditions and financial market structures. To address this diversity, the ECB employs
a combination of policy instruments and communication strategies to influence
financial conditions and interest rates uniformly across member countries. This
approach helps to mitigate disparities in interest rates and supports economic
convergence within the euro area.
In contrast, the Federal Reserve's decision to implement interest on reserves
(IOR) in 2008 marked a significant shift in its monetary policy toolkit. Interest on
reserves allows the Fed to influence short-term interest rates by adjusting the rate paid
on excess reserves held by banks at the Fed. While this tool provides the Fed with
greater control over short-term rates, its introduction coincided with a period of
unprecedented financial turmoil and economic instability during the global financial
crisis.
During this period, the ECB's operational framework and policy approach
proved resilient in maintaining stability in short-term interest rates within the euro
area. The ECB's commitment to providing ample liquidity to the banking system
through its refinancing operations helped to alleviate funding pressures and stabilize
financial markets during times of market stress. This proactive stance underscored the
ECB's role as a provider of liquidity and stability in the euro area financial system.
Moreover, the ECB's communication strategy has played a crucial role in
guiding market expectations and supporting its interest rate management objectives.
Through regular press conferences, speeches by ECB officials, and the publication of
economic forecasts and policy decisions, the ECB enhances transparency and clarity
regarding its policy intentions. This transparency helps to reduce uncertainty in
financial markets and facilitates the effective transmission of monetary policy.
Looking ahead, the ECB continues to adapt its monetary policy framework
and operational tools to address evolving economic challenges and financial market
developments. As global economic conditions change and new challenges emerge, the
ECB remains committed to its mandate of maintaining price stability and supporting
economic growth across the euro area. By leveraging its operational expertise,
communication strategy, and commitment to transparency, the ECB aims to sustain its
track record of effectively managing short-term interest rates and achieving its policy
objectives in a dynamic and interconnected global economy.
In summary, the ECB's success in keeping short-term interest rates close to
target prior to the Federal Reserve's implementation of interest on reserves in 2008
reflects its robust policy framework, operational effectiveness, and commitment to
maintaining price stability. By employing a transparent and proactive approach to
monetary policy, the ECB has demonstrated its ability to navigate economic
challenges and support financial stability within the euro area.
c. Linking Tools to Objectives: Making Choices
Monetary policymakers use the various tools they have to meet the objectives
society gives them. Their goals—low and stable inflation, high and stable growth, a
stable financial system, stable interest and exchange rates—are (or should be) given to
them by their elected officials. But day-to-day policy is left to the technicians, who
must then decide which tools are the best for the job. Over the years, a consensus has
developed among monetary policy experts, both inside and outside most central
banks, that (1)$the reserve requirement is not useful as an operational instrument,
(2)$central bank lending is necessary to ensure financial stability, and (3)$short-term
interest rates are the conventional tool to use to stabilize short-term fluctuations in
prices and output, we will see how exceptional conditions—such as dysfunctional
financial markets or nominal short-term interest rates near the effective lower bound
—can lead to the use of unconventional policy tools, but even those tools aim to
influence some market interest rate. The logic of this conclusion is straightforward. To
follow it, let’s start by listing the features that distinguish good policy instruments
from bad$ones.
Requiring that a monetary policy instrument be observable and controllable
and have predictable impact leaves us with only a few options to choose from. The
reserve requirement won’t work, as we have seen, because the effect of changes in the
requirement is difficult to anticipate. Then there are the components of the central
bank’s balance sheet—commercial bank reserves, the monetary base, loans, and
foreign exchange reserves—as well as their prices—various interest rates and the
exchange rate. But how do we choose between controlling quantities and controlling
prices? Over the years, central banks have switched from one to the other. For
example, from 1979 to 1982, the Fed did try targeting bank reserves, with an eye
toward reducing the inflation rate from double-digit levels. Inflation fell quickly, so in
a sense the policy was a success. But one side effect of choosing to control reserves
was that interest rates became highly variable, rising from 14 percent to over
20$percent and then falling to less than 9 percent, all in a period of less than six
months.
The consensus today is that the Fed’s strategy of targeting reserves rather than
interest rates in the period from 1979 to 1982 was a way of driving interest rates to
levels that would not have been politically acceptable had they been announced as
targets. Even in an environment of double-digit inflation rates, the FOMC could not
explicitly raise the target federal funds rate to 20 percent. By saying they were
targeting the quantity of reserves, the committee members escaped responsibility for
the high interest rates. When inflation had fallen and interest rates came back down,
the FOMC reverted to targeting the overnight interest rate. And that is what it has
done ever since. (Although the Fed’s balance sheet expansion after 2008 did not aim
to alter the federal funds rate target, it did aim to reduce longer-term interest rates.)
Appearances and politics aside, there is a very good reason that the leading central
banks in the world today choose to target an interest rate rather than some quantity on
their balance sheet. Interest rates are the primary linkage between the financial system
and the real economy, so stabilizing growth means keeping interest rates from being
overly volatile. In the context of choosing an operating target, that means keeping
unpredictable changes in reserve demand from influencing interest rates and feeding
into the real economy. The best way to do this is to target interest rates.
When you focus central bankers’ attention on a well-articulated objective, you
get better policy. During the 1990s, a number of countries adopted a policy
framework called inflation targeting in an effort to improve monetary policy
performance. Today, central banks in countries that produce nearly two-thirds of
global GDP operate a de jure or a de facto inflation-targeting regime. Countries that
embraced inflation targeting achieved both lower inflation and (at least until the
financial crisis of 2007–2009) more stable real economic growth. Inflation targeting
focuses directly 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—because the central bank routinely acts to achieve it—everyone believes
that inflation will be low. Long-term expectations of low inflation act to anchor low
long-term interest rates and promote economic growth. So inflation targeting is
designed to convince people that monetary policy will deliver low inflation, and if
central bankers are resolute, it usually works.
Often, central banks that employ inflation targeting operate under what has
been described as a hierarchical mandate, in which price stability comes first and
everything else comes second. Australia, Chile, South Africa, and the United
Kingdom are among the roughly two dozen countries that target inflation in this way.
Most observers put the ECB in this group as well. The hierarchical approach contrasts
with the Fed’s dual mandate, in which the goal of price stability (together with low
long-term interest rates) and the goal of maximum employment are on equal footing.
Nevertheless, consistent with inflation targeting, the Fed announced a quantitative
inflation objective in January 2012 but set no employment target. To understand how
inflation targeting works, let’s look at the British example. The Bank of England Act
of 1998 granted the Bank of England independence but also dictated its objective: to
deliver price stability, as defined by the government’s inflation target. A nine-member
Monetary Policy Committee (MPC) meets monthly to determine short-term interest
rates in an effort to meet this objective, which has been defined as annual consumer
price inflation of 2 percent. Because transparency is a crucial part of inflation
targeting, the Bank of England releases the interest rate decisions of the MPC along
with the minutes of its meetings the day after they conclude and publishes quarterly
forecasts of inflation in its Inflation Report.
By focusing on a clearly defined and easily observable numerical inflation
statistic and by requiring frequent public communication, inflation targeting increases
policymakers’ accountability and helps establish their credibility. Not only do central
bankers know what they are supposed to do, but everyone else does, too. By reducing
any incentive that future policymakers might have to renege on the commitment to
low inflation, this framework of communication and accountability helps overcome
the time-consistency problem. The result is not just lower and more stable inflation
but—usually—higher and more stable economic growth. Nevertheless, as we saw in
the global crisis of 2007– 2009, inflation targeting is not sufficient to prevent financial
disruptions that undermine economic stability.
d. A Guide to Central Bank Interest Rates: The Taylor Rule
Interest rate setting is about numbers. Policymakers both pick a specific target
and choose when to implement it. How do they do it? The answer is that they have a
large staff who distill huge amounts of information into manageable sets of policy
recommendations. Committee members digest all the information, meet, and reach a
decision. We could try to list all the factors they consider and explain how each
influences the committee’s decision, but that would take another book. What we can
do is study a simple formula that approximates what the FOMC does. Called the
Taylor rule after the economist who created it, Professor John Taylor of Stanford
University, it tracks the actual behavior of the target federal funds rate and relates it to
the real interest rate, inflation, and output.
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 had been close to the average real short-term rate. The inflation gap is current
inflation minus an inflation target, both measured as percentages; the output gap is the
percentage deviation of current output (real GDP) from potential output. When
inflation exceeds the target level, the inflation gap is positive; when current output is
above potential output, the output gap is positive. The Taylor rule says that the target
federal funds rate should be set equal to the natural rate of interest plus the current
level of inflation, plus a factor related to the deviations of inflation and output from
their target or normal levels. For example, if the natural rate of interest is 2 percent,
inflation is currently 2 percent, the inflation target is 2 percent, and real GDP equals
its potential level so there is no output gap, then the target federal funds rate should be
set at 2 + 2 + 0 + 0 = 4 percent.
This rule functions like a thermostat, tuning the policy interest rate target if the
economy (measured as inflation and output) is too hot or cold. It makes intuitive
sense: 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 (current real GDP equals
potential GDP), then the target federal funds rate should be set at the natural rate of
interest plus target inflation. The Taylor rule has some interesting properties. Consider
what happens if inflation rises by 1 percentage point, from 2 percent to 3 percent, and
the inflation target is 2$percent (assume that everything else remains the same). What
happens to the target federal funds rate? The increase in inflation affects two terms in
the Taylor rule, current inflation and the inflation gap. Because the inflation target
doesn’t change, both these terms rise 1 percentage point. The increase in current
inflation feeds one for one into the target federal funds rate, but the increase in the
inflation gap is halved. A 1-percentage-point increase in the inflation rate raises the
target federal funds rate 1½ percentage points.
Significantly, the Taylor rule tells us that for each percentage-point increase in
inflation, the real interest rate, which is equal to the nominal interest rate minus
expected inflation, goes up half a percentage point (assuming that expected inflation
matches actual inflation). Because economic decisions depend on the real interest
rate, this means that higher inflation leads policymakers to raise the inflation-adjusted
cost of borrowing, thereby slowing the economy and ultimately reducing inflation. If
central banks failed to do this, if they allowed the real interest rate to fall following an
increase in inflation, the result would be further increases in production and further
increases in inflation. The Taylor rule also states that for each percentage point output
is above potential— that is, for each percentage point in the output gap—interest rates
will go up half a percentage point.
The fractions that precede the terms for the inflation and output gaps—the
halves in equation (1)—depend both on how sensitive the economy is to interest rate
changes and on the preferences of central bankers. The more central bankers care
about inflation, the bigger the multiplier for the inflation gap and the lower the
multiplier for the output gap. When a shock occurs, these differences influence the
speed with which the inflation target is restored, or the output gap eliminated.
Returning to the United States, we see that implementing the Taylor rule requires four
inputs: (1) the natural rate of interest; (2) a measure of inflation; (3) a measure of the
inflation gap; and (4) a measure of the output gap. The natural rate of interest can and
does change. Although 2 percent remains a common estimate, as a result of the weak
postcrisis recovery many observers have lowered their estimate of the natural rate.
Next we need to add measures of current inflation and the inflation gap. What
index should we use? While the CPI is widely known, economists believe that the
price index of personal consumption expenditure (PCE) is a more accurate measure of
inflation and, in 2012, the Fed set its inflation goal in terms of the annual rise of this
measure. The index comes from the national income accounts and is based on the “C”
in “Y$=$C$+ I + G + X − M.” Using the Fed’s inflation goal of 2 percent, and
assuming the natural rate of interest is 2 percent, the neutral target federal funds rate is
4 percent (2 plus 2). For the output gap, the usual choice is the percentage by which
GDP deviates from a measure of its trend, or potential plots the FOMC’s actual target
federal funds rate, together with the rate predicted by the Taylor rule (assuming 2
percent for both the natural rate of interest and the inflation target). The result is
striking: The two lines are reasonably close to each other. The FOMC usually changed
the target federal funds rate when the Taylor rule predicted it should. While the rule
didn’t match policy exactly, it did predict what policymakers would do in a general
way. And what is really remarkable is that Professor Taylor created his rule around
1992, at the beginning of the period shown in the graph.
Before we get carried away and replace the FOMC with an equation, or begin
betting in the financial markets based on the Taylor rule’s predictions, we should
recognize some caveats. First, at times the target rate does deviate from the Taylor
rule, and with good reason. The Taylor rule is too simple to take account of sudden
threats to financial stability, such as the terrorist attacks of September 11, 2001.
Indeed, we can learn from the periods in which the policy rate deviates from the
Taylor rule. For example, why did the FOMC set the federal funds rate target below
the Taylor rule in 1992–1993, 2002–2005, and 2008–2013. The answer is that these
periods were characterized by at least one of two factors: (1)$unusually stringent
conditions across an array of financial markets or (2) deflationary worries that arose
as nominal interest rates approached zero. When financial conditions are much
stronger or much weaker than usual, policymakers seeking to stabilize the economy
may set an interest rate target that differs substantially from the Taylor rule. We can
think of financial conditions as a measure that indicates the state of a broad array of
markets, including both the prices of assets and the volume of transactions in these
assets. Euphoric conditions are often associated both with high prices and volumes in
asset trading and with easy access to credit, while depressed conditions are linked
with the opposite states. Although the policy target rate influences financial
conditions, the link is a loose one: financial conditions can and do vary substantially,
even in the absence of any changes in the policymakers’ target interest rate.
Financial conditions affect policy choices because they alter prospects for
private spending and for inflation. Lax or easy conditions mean that households and
firms are more readily able to borrow, to spend out of wealth, and to invest. Plunging
asset prices and the loss of credit work in the opposite direction. Consequently, a
tightening or easing in financial conditions is a signal to policymakers about the
future path of economic activity and inflation, and this affects their evaluation of
appropriate levels of the interest rate and the Taylor rule. An interesting example of
this interaction arose in 2004–2006, when Federal Reserve policymakers chose to
raise the target federal funds rate in an effort to moderate economic growth and
inflation risks. However, from the perspective of broad financial conditions, policy
remained accommodative, and the economy continued to grow vigorously. This
pattern suggests that the Fed hiked rates too cautiously, a view reinforced by the
subsequent pickup of inflation.
In 2008, even though the Fed cut rates below the Taylor rule, the collapse of
financial conditions and the economy suggests that it was too cautious. Just like Japan
in the 1990s, the Fed did not act early enough to prevent the interest rate implied by
the Taylor rule from sinking below zero. Indeed, for the first time in at least 50 years,
in 2009 the Taylor rule suggested that the appropriate policy rate was negative for the
United States as well as for several other major economies. In this environment, even
a zero-rate target probably was too high to counter weakness in the global economy.
Yet, as we have seen, a central bank is unable to set its policy rate below the effective
lower bound (ELB) on nominal rates, which (so long as cash offers a zero rate of
return) is not far below zero.
Because of this ELB, central banks naturally wish to avoid circumstances that
would require a very negative policy rate. Thus, if the economy is weak and inflation
is both low and falling below the central bank’s objective, policymakers might set
their target rate temporarily below the one implied by the Taylor rule. This approach
accepts as a cost the possibility that inflation will rise temporarily above the objective
in the future. The benefit is a lower risk of hitting the ELB. Such a risk management
approach to policy was a key element of the FOMC’s thinking when during 2002–
2005 it set the target federal funds rate below the level implied by the Taylor rule. Yet,
some economists— including the creator of the Taylor rule—now argue that the Fed’s
low rate target during this period amplified the housing bubble and contributed to the
crisis that followed.17 Finally, two other problems cast doubt on the practicality of the
Taylor rule as a guide for monetary policy decisions. The first is uncertainty about the
natural rate of interest. As of early 2019, one estimate by Fed researchers put the
natural rate at around _1 2 percent rather than the historical level of 2 percent.18
That’s a big difference for policymakers.
The second problem is the lack of reliable real-time data. So, while researchers
might be able to make good monetary policy for, say, 2015 using the Taylor rule and
the data available to us today, that ability really isn’t of much practical use.
Policymakers are not “Monday-morning quarterbacks”: they have no choice but to
base their decisions on the available information, which is generally less than
completely accurate. Their good judgment is the key to successful monetary policy.
e. Unconventional Policy Tools
We have seen that most central banks set a target for the overnight interbank
lending rate in an effort to stabilize the economy and keep inflation low. However,
there are two circumstances when additional policy tools can play a useful
stabilization role: (1)$when lowering the target interest rate to zero (or to the ELB) is
not sufficient to stimulate the economy and (2)$when an impaired financial system
prevents conventional interest rate policy from supporting economic growth.19 In
both cases, unconventional monetary policy can add to the stimulus already coming
from conventional policy. When these circumstances arose during the financial crisis
of 2007–2009, in the euro-area crisis that followed, and in the course of Japan’s long
battle against deflation, central banks used a variety of unconventional policy tools to
supplement conventional interest rate policy. With continued use by many central
banks, these tools have become less and less “unconventional,” but we continue to
categorize them in this way to simplify matters. In this section, we’ll examine some of
those tools.
First, however, let’s dismiss a common belief: that monetary policy becomes
ineffective when the target rate is at the ELB and the financial system is impaired. In
these circumstances, skeptics often speak of a “liquidity trap,” in which monetary
expansion has no impact. Central banks are said to be “pushing on a string.” In fact,
central banks have powerful tools at their disposal, even in such extreme
circumstances. But the problem for central bankers is that the impact of these
unconventional tools is less predictable than that of day-to-day interest rate policy.
And being responsible public officials, policymakers are loath to treat the economy as
a laboratory, risking sudden increases in inflation and the like. This means that using
unconventional policies is much more complicated than simply changing an interest
rate target. In addition, the exit from unconventional policies poses risks. For these
reasons, central bankers use unconventional tools only in situations when interest rate
policy is clearly insufficient for economic stabilization.
What are the key unconventional policy approaches? While various central
banks may label them differently, there are three broad categories: (1)$forward
guidance, in which the central bank communicates its intentions regarding the future
path of monetary policy; (2) quantitative easing (QE), in which the central bank
supplies aggregate reserves beyond the quantity needed to lower the policy rate (such
as the federal funds rate in the United States) to its target (usually zero or lower); and
(3) targeted asset purchases (TAP), in which the central bank alters the mix of assets it
holds on its balance sheet in order to change their relative prices (interest rates) in a
way that stimulates economic activity. When the Fed refers to its unconventional
policy of large-scale asset purchases, the term covers both targeted asset purchases
and, if the purchases are unsterilized, quantitative easing. That is, Fed large-scale
asset purchases are QE, TAP, or both. In the next section we describe how these three
unconventional mechanisms work. Finally, we’ll look at how one of the four
conventional policy tools—paying interest on reserves—helps a central bank exit
smoothly from unconventional policies (like QE and TAP) that expand the central
bank’s balance sheet or result in the acquisition of illiquid assets.
The simplest unconventional approach a central bank can take is to provide
“forward guidance”—guidance today about policy target rates in the future. For
example, if policymakers believe that inflation will stay well below their objective,
they might express the intention to keep the policy target rate low for an extended
period (see the section Inflation Targeting on pages 496–497). This forward guidance
could have a specific termination date, or its duration could be made contingent on a
future change in economic conditions (say, an upturn in business activity or a rise of
employment). How does forward guidance influence the economy and inflation? To
stimulate activity, central bank forward guidance aims at lowering the long-term
interest rates that affect private spending. Consequently, what central bankers say
about their future plans can be very important. However, to be effective, forward
guidance needs to be credible. Otherwise, long-term market interest rates may not
respond as the central bank hopes.
In the past, policymakers used several mechanisms to make their
commitments about future policy credible. For example, from the late 1930s until
1951, the Fed purchased long-term Treasury bonds with the objective of capping their
interest rates at an artificially low level.20 However, exiting from such intervention
can be disruptive because investors face the prospect of immediate capital losses
when yields rise. Consequently, if bondholders fear that the central bank will stop
intervening, they may sell immediately. In such circumstances, the only way to
sustain the cap on long-term interest rates would be for the central bank to buy all the
bonds, many central banks engage in inflation targeting; this policy framework affects
the credibility of forward guidance and can be reinforced by it. For example, forward
guidance aimed at keeping interest rates low will be most credible for an inflation-
targeting central bank precisely when inflation is expected to stay below target for
some time. The reason is that the guidance is time consistent: Future policymakers
will not wish to renege. For the same reason, forward guidance can be used to counter
the risk of deflation when the target interest rate is at the ELB. How has the Federal
Reserve used forward guidance? The answer is, with increasing frequency and
refinement. In 2002–2004, the FOMC believed that inflation would sink undesirably
low and worried about the possibility of deflation. Accordingly, the FOMC stated that
its target federal funds rate would stay low for the “foreseeable future” or for a
“considerable period.” When the Fed began to tighten in 2004, it assured markets that
the withdrawal of accommodation would occur at a “measured pace” to avoid fears of
sharp rate hikes.
In late 2008, having lowered the policy target to zero during the crisis,
policymakers announced that “weak economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for some time.”21 In December
2012, the FOMC went further, stating its expectation that “highly accommodative
monetary policy will remain appropriate for a considerable time after . . . the
economic recovery strengthens.”22 It also introduced specific thresholds (projected
inflation above 2½ percent or an unemployment rate of less than 6½ percent) for
raising the target rate. Although forward guidance can be effective, the Fed’s
experience suggests that it is difficult to anticipate and reach consensus on the
desirable policy path and to communicate these policy intentions in a simple yet
precise way. Another concern is the potential for disturbing side effects, including
asset price bubbles. Consequently, forward guidance is provided most often in
extraordinary circumstances—when a general understanding of how the Fed usually
responds to economic and financial conditions is insufficient to manage expectations.
Quantitative easing (QE) is perhaps the most well-known mechanism to relax
the monetary stance when policymakers no longer wish to lower the target rate. As we
saw, QE occurs when the central bank expands the supply of aggregate reserves to the
banking system beyond the level that would be needed to maintain its policy rate
target. The central bank uses the proceeds from this reserve expansion to buy assets,
thereby expanding its overall balance sheet, the central bank adds $1 billion to
commercial bank reserves held in their accounts at the Fed and acquires $1$billion in
Treasury bonds. At a market federal funds rate equal to the interest on excess reserves,
an addition to aggregate reserves no longer reduces the funds rate. As a result, the Fed
can add limitlessly to reserves—and to the assets on its balance sheet—without
depressing the market federal funds rate. The amount of QE is the volume of reserves
in excess of the level needed to keep the policy rate at its target, in this case the IOER
rate.
A simple thought experiment shows that QE can shape the path of economic
growth and inflation, even if the financial system is impaired. Imagine that the central
bank expands reserves to the point where it (or the fiscal authority that it finances
with new reserve issuance) purchases all of the assets in the economy. For QE to be
ineffective, it would imply that the central bank could do so without influencing the
level of prices! This nonsensical outcome means that QE, applied with sufficient
vigor, and with the cooperation of the government, can alter economic growth and
inflation prospects. Nonetheless, it is difficult to predict the effects of QE. Fed
policymakers argue that their balance sheet expansion helped lower long-term interest
rates, but there is disagreement among experts about the impact—especially in deep,
liquid markets.23 Moreover, the mechanism by which QE affects economic prospects
is not clear. When interest rates are at the rate paid on excess reserves, banks are
indifferent between reserve deposits at the central bank and short-term government
debt. These assets are riskless, so an increase in the supply of reserves (QE) may
simply lead banks to hold more of them rather than provide additional loans to
households and firms. This is one version of a “liquidity trap.”
