“Key Issues for Monetary Policy-Makers” Federal Reserve Bank of New York Raymond Stone Stone & McCarthy Research Associates December 9, 2008

With the Fed Funds Rate Approaching Zero, Is The Fed Running Out of Ammunition?

Fed’s Policy Toolkit Interest Rate Policy Credit Policy

Interest Rate Policy--addresses the setting of the Fed Funds target. This policy is based on the Fed's dual mandate.

Credit Policy—Addresses how the Federal Reserve might use its balance sheet to sustain "Financial Stability". Examples of Credit Policy Term Auction Facility (TAF) Primary Dealer Credit Facility (PDCF) Commercial Paper Financing Facility (CPFF) Money Market Investors Funding Facility (MMIFF) Term Asset-Backed Securities Loan Facility (TALF) Program to purchase direct obligations of GSEs and GSE sponsored MBS More to Come?

Benefits of Distinguishing Between Interest Rate and Credit Policy In this era of Fed Transparency, the framing of the policy debate in terms of Interest Rate and Credit Policy provides for a crisp account of the Fed's thinking. There may be times when Interest Rate Policy and Credit Policy direction could conflict The distinction between credit policy and interest rate policy provides a vehicle for the Fed to better articulate the thinking underpinning policy decisions.

Questions That Must Be Addressed What is the role of the FOMC? Up until now the job of the FOMC was to set the funds target, now what? Has credit policy taken away responsibility from the FOMC and shifted it to the Federal Reserve Board and possibly towards the FRBNY? How does the Fed communicate Credit Policy?

Credit Policy involves managing the Fed’s Balance Sheet to target liquidity to address specific problems.

Up until the Lehman Bankruptcy, Credit Policy changed only the composition, not the size, of the Fed’s Balance Sheet

Up until mid September 2008, the Fed had accommodated the various lending/liquidity facilities by selling Treasuries— reducing SOMA. There are limits to how low the SOMA can go

Following the Lehman debacle, Interbank Funding became especially strained…Credit Policy needed to become still more aggressive

Commercial Paper Market Shut Down for a Time

The Strains Went Well Beyond the Money Markets

In response to funding strains and stress on bank capital positions, banks tightened lending standards

Post-Lehman, the Fed provided liquidity without attempting to sell Treasuries (reduce SOMA), or otherwise sterilize the “Reserve Affect”

Fed’s Balance Sheet more than doubled in size in a few short weeks

Excess Reserves Surged

To keep the Fed Funds Rate from falling to zero, the Fed started paying interest on bank reserves, effectively setting a floor on the funds rate…

The expansion of bank reserves far beyond that legally required to satisfy mandated "reserve requirements" is tantamount to a "Quantitative Easing". Intentional Quantitative Easing—Buying Treasury securities with the intent to expand bank reserves far beyond required reserves Consequential Quantitative Easing—As a consequence of Credit Policy bank reserves expand far beyond required reserves

Ultimately, steps taken by the Fed (Liquidity), FDIC (Insurance), and Treasury (Capital Injections) have been aimed at encouraging bank lending…But

Is the Fed Running Out of Bullets? What Else Can the Fed Do? Use communications policy to shape expectations regarding the future course of policy, with an eye on impacting on the level of immediate and longer-term interest rates via the "expectations theory" of the yield curve. The Fed could increase the size of its balance sheet still further to flood the system with excess reserves, the so-called "Quantitative Easing" Changing the composition of the Fed's balance sheet to buy more longer-term Treasury securities in hopes of impacting on longer-term interest rates. Still more Credit Policy, lending/liquidity facilities targeting specific credit issues i.e. mortgages, consumer credit, auto loans, etc

The Monetary Transmission Mechanism: Some Questions and Further Answers (Kenneth Kuttner and Patricia Mosser, FRBNY Economic Policy Review, May 2002)