Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 3 Chapter Eighteen Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 3

Unconventional Policy Tools Non-traditional policy tools can play a useful stabilization role: When lowering the target interest-rate to zero is not sufficient to stimulate the economy; and When an impaired financial system prevents conventional interest-rate policy from supporting the economy. 2008 – present.

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 zero.

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 TAP, QE, or both

Forward Guidance The simplest unconventional approach is for the central bank to provide forward guidance. Express the intent to keep the policy target low for an extended period of time. Talk long-term rates down by convincing the public of the intent to keep ST rates low for an extended period of time. However, to be effective, forward guidance needs to be credible. If not, markets may not respond as the central bank hopes.

Forward Guidance Between 2002 and 2004, the FOMC issued an unconditional commitment indicating that its target funds rate would stay low for the “foreseeable future” or for a “considerable period.” In 2004, it assured markets that the withdrawal of accommodation would occur at a “measured pace” to avoid fears of sharp rate hikes.

Forward Guidance In 2008, the FOMC adopted a conditional approach as the financial crisis deepened. They announced that “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

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. The next slide illustrates the impact of QE on supply and demand in the federal funds market.

Quantitative Easing At a rate of zero, banks hold cash rather than lend. The Fed can add limitlessly to reserves without affecting the market federal funds rate. QE is the difference between A and B.

Quantitative Easing Fed policymakers argue their balance sheet expansion helped to lower long-term interest rates, but there is disagreement on the impacts. An increase in the supply of reserves (QE) may simply lead banks to hold more of them rather than provide additional loans.

Quantitative Easing QE may reinforce the impact of forward guidance 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.

Targeted Asset Purchases Targeted asset purchases (TAP) shift the composition of the balance sheet toward selected assets in order to boost their relative price lower selected interest rates and stimulate economic activity. In the absence of private demand for the risky asset, the central bank’s purchase makes credit available where none existed. Purchase relatively illiquid assets.

Targeted Asset Purchases The Fed purchased over $1 trillion in MBS and more than $1.3 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.

Targeted Asset Purchases 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.

Making an Effective Exit QE and TAP assets are typically more difficult to sell. A Fed may be unable to sell assets and withdraw reserves from the banking system fast enough to increase the policy rate when it desires. However, the Fed has several policy options that allow them to tighten (increase target FFR) without having to sell assets.

Making an Effective Exit Raise the Deposit Rate The deposit rate sets the floor for the market federal fund rate.

Making an Effective Exit Paying interest on reserves allows the Fed to use two powerful policy tools independently of one another: It can adjust the target FFR for interbank loans without changing the size or composition of its balance sheet, and It can adjust the size and composition of its balance sheet without changing the target interest rate for interbank loans.

Making an Effective Exit This means the central bank can change its balance sheet in a fashion consistent with financial stability and keep inflation under control. It can avoid a fire sale by simply raising the deposit rate that they pay on reserves.