1. Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Modern Monetary Policy and the Challenges Facing Central Bankers Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter Twenty-Three

2. 23-2 Introduction In this chapter we will: 1.Examine the transmission mechanism of monetary policy, and 2.Answer the questions of why, in the aftermath of the financial crisis of 2007-2009, monetary policy and the challenges facing central bankers are especially difficult.

3. 23-3

4. 23-4 The Monetary Policy Transmission Mechanism We need to examine the various ways in which changes in the policy-controlled interest rate influence the quantity of aggregate output demanded in the economy as a whole. These are collectively referred to as the channels of the monetary policy transmission mechanism. We will begin with the traditional interest-rate and exchange-rate channels. We will then study the role of banks and finally the importance of stock price movements.

5. 23-5 The Traditional Channels: Interest Rates and Exchange Rates Easing of monetary policy - a decrease in the target nominal interest rate, which lowers the real interest rate - leads to a depreciation of the dollar. The less valuable dollar: Drives up the cost of imported goods and services, reducing imports from abroad, and Makes U.S. goods and services cheaper to foreigners, so they will buy more of them.

6. 23-6 The Traditional Channels: Interest Rates and Exchange Rates However, the interest-rate channel is not very powerful. Data suggest that the investment component of total spending isn’t very sensitive to interest rates. While a small change in the interest rate does change the cost of external financing, it doesn’t have much effect on investment decisions.

7. 23-7 The Traditional Channels: Interest Rates and Exchange Rates The impact of short-term interest rates on household decisions is also rather modest. The problems is that people’s decisions to purchase cars or houses depend on longer-term interest rates rather than the policymakers’ short-run target rate. Household consumption decisions will only change to the extent that the target interest rate affects long-term interest rates.

8. 23-8 The Traditional Channels: Interest Rates and Exchange Rates As for the effect of monetary policy on the exchange rate, once again, theory and practice differ. The policy-controlled interest rate is just one of many factors that shift the demand and supply for the dollar on foreign exchange markets.

9. 23-9 The Traditional Channels: Interest Rates and Exchange Rates We must conclude that the traditional channels of monetary policy transmission aren't very powerful. Yet evidence shows that monetary policy is effective. Something else must be amplifying the impact of monetary policy changes on real economic activity.

10. 23-10 Correlation does not imply causality. In economics, establishing a causal relationship is much more difficult. We need to look for clear evidence that particular monetary policy actions are unrelated to some third factor that drives up the interest rate, forcing growth down at the same time.

11. 23-11 Bank-Lending and Balance-Sheet Channels Four times a year the Fed conducts an opinion survey on bank-lending practices. This survey provides important information to monetary policymakers. Without it they would not be able to tell whether a change in the quantity of new loans granted resulted from a shift in supply or a shift in demand.

12. 23-12 Bank-Lending and Balance-Sheet Channels The fact is that banks are essential to the operation of a modern industrial economy. They direct resources from savers to investors and solve problems caused by information asymmetries. Banks are also the conduit through which monetary policy is transmitted to the economy. To understand monetary policy change completely, we need to look carefully at how they affect the banking system. We need to examine the impact of policy changes on banks and bank lending.

13. 23-13 Banks and Bank Lending Borrowers do not have access to direct capital market financing. They must go to banks. When banks stop lending, a large class of borrowers simply can’t obtain financing. Bank lending is an important channel through which monetary policy affects the economy. By altering the supply of funds to the banking system, policymakers can affect banks’ ability and willingness to lend. The bank-lending channel of monetary policy transmission.

14. 23-14 Banks and Bank Lending We see that an open market purchase has a direct impact on the supply of loans. But, financial regulators can also influence bank-lending practices. Changes in financial regulations, such as an increase or decrease in the amount of capital banks are required to hold when they make certain types of loans. This will have an impact on the amount of bank lending.

15. 23-15 Banks and Bank Lending Figure 23.2 plots two surveys of how credit conditions for large and small nonfarm businesses vary over time. One line shows the net share of banks tightening standards for loans to large firms. The other shows the share of small firms that view credit as harder to obtain minus the share that view credit as easier to obtain. In both cases, credit conditions typically tighten in recessions and ease in booms.

16. 23-16 Banks and Bank Lending Note, however, that small firms sometimes face tight credit conditions even in economic recoveries. A cutback in lending to creditworthy small firms or households limits the pace of national economic growth during recovery. Policymakers worry that the recovery from a recession caused by a financial crisis may be weaker than the recovery from a recession caused by other factors.

17. 23-17 Banks and Bank Lending

18. 23-18 The problem with people buying more during lower interest rates is that some might take on more debt than they can manage. Don’t borrow on the assumption that your income is going to increase rapidly. This is similar to depending on inflation to bail you out, so don’t depend on that either.

19. 23-19 Firms’ Balance Sheets and Household Net Worth The balance-sheet channel of monetary policy transmission works because monetary policy has the direct influence on the net worth of potential borrowers. An easing of monetary policy improves firms’ and households’ balance sheets, increasing their net worth. Increases in net worth reduce the problems of moral hazard and adverse selection. This lowers information costs of lending and allows borrowers to obtain financing more easily.

20. 23-20 Firms’ Balance Sheets and Household Net Worth How does monetary policy expansion improve borrowers’ net worth? 1.Expansionary policy drives up asset prices, increasing the value of firms and the wealth of households. 2.Lower interest rates reduce the burden of repayment of current loans of borrowers.

21. 23-21 Firms’ Balance Sheets and Household Net Worth At lower interest rates, a person with a variable rate loan enjoys lower interest payments. The percentage of this person’s income that is devoted to loan payments will be lower. As interest rates fall, the supply of loans increases. Information services are central to banks’ role in the financial system. They help to address the problems of adverse selection and moral hazard.

22. 23-22 Firms’ Balance Sheets and Household Net Worth Inferior information leads to an increase in adverse selection. This: Reduces bank lending, Lowers investment, and ultimately Depresses the quality of aggregate output demanded.

23. 23-23 Firms’ Balance Sheets and Household Net Worth The channels of monetary policy transmission depend on the structure of the financial system. To the extent that banks are unimportant sources of funds for firms and individuals, the bank-lending channel is not tremendously important. While technology has made the processing of increasing amount of information easier and cheaper, it seems unlikely to solve the problems of adverse selection and moral hazard.

24. 23-24 Asset-Price Channels: Wealth and Investment When the interest rate moves, so do stock prices. This relationship is referred to as the asset- price channel of monetary policy transmission. Recall that the fundamental value of a stock is the present value of the stream of its future dividends. The lower the interest rate, the higher the present value is and the higher the stock price.

25. 23-25 Asset-Price Channels: Wealth and Investment When policymakers reduce their interest-rate target, it drives the mortgage rate down. This means higher demand for residential housing, driving up the prices of existing homes. Stock and property prices affect both individual consumption and business investment. Higher stock and real estate prices means an increase in wealth. An increase in wealth means higher consumption.

26. 23-26 Asset-Price Channels: Wealth and Investment As stock prices rise, firms find it easier to raise funds by issuing new shares. As financing become less expensive, more investments become profitable.

27. 23-27 The Monetary Policy Transmission Mechanism

28. 23-28 Financial Crisis Obstructs Monetary Policy Transmission What prevented policy easing from being transmitted as usual to the real economy? The crisis intensified the fundamental problems of asymmetric information that affect the provision of credit in a modern economy. The widespread losses at intermediaries in general and the heightened uncertainty about the damage suffered by specific intermediaries reduced confidence. This virtually cut off the availability of credit to many of them.

29. 23-29 Financial Crisis Obstructs Monetary Policy Transmission Funding liquidity dried up. Households’ and nonfinancial firms’ net worth fell substantially, reducing their ability to borrow so they cut spending. The result of all this was a destabilizing feedback loop between worsening economic prospects and the deterioration of financial conditions that influence spending.

30. 23-30 Financial Crisis Obstructs Monetary Policy Transmission The bottom-line is that when the policy transmission mechanism is obstructed, central banks cannot assume that a cut in their target policy rate will ease the financial conditions that influence the economy. Central banks must always take into account the workings of the monetary policy transmission mechanism in order to achieve their goals of economic and price stability.

31. 23-31 Why did Japan’s economy fail to respond to interest rates near zero? One possibility is that the stock market collapse lowered borrower net worth. In addition, with borrowers unable to repay, banks had virtually no capital and could not make additional loans.

32. 23-32

33. 23-33 The Challenges Modern Monetary Policymakers Face To do their jobs well, central bankers need a detailed understanding of how both the financial system and the real economy will react to their policy changes. Modern policymakers face a series of daunting challenges. We will look at three challenges that grew more prominent thanks to the financial crisis of 2007-2009.

34. 23-34 The Challenges Modern Monetary Policymakers Face Stock prices and property values have a tendency to go through boom and bust cycles. Policymakers’ options are limited, as we have seen by the fact that the nominal interest rate cannot fall below zero. The structures of the economy and the financial system are constantly evolving.

35. 23-35 Booms and Busts in Property and Equity Prices Nearly everyone agrees that we would all be better off without skyrocketing increases in property and stock prices followed by sudden collapses. Abrupt changes in asset prices, like the U.S house price bubble, affect virtually every aspect of economic activity.

36. 23-36 Booms and Busts in Property and Equity Prices Bubbles are particularly damaging because the wealth effects they create cause consumption to surge and then contract just as rapidly. Bubbles are identified after the fact by a sharp rise then a sharp decline in prices. The collapse of the Internet bubble in the 1990s had a relatively minor impact because intermediaries faced limited credit exposure and remained well capitalized.

37. 23-37 Booms and Busts in Property and Equity Prices In contrast, the loss of capital in the financial system in 2007-2009 could have led to catastrophe without extraordinary government actions. The devastating worldwide effects of the reversal in U.S. house prices beginning in 2006 has focused renewed attention on how monetary policymakers should react to asset price bubbles.

38. 23-38 Booms and Busts in Property and Equity Prices

39. 23-39 Booms and Busts in Property and Equity Prices

40. 23-40 Booms and Busts in Property and Equity Prices Proponents of a policy of “leaning against bubbles” say that stabilizing inflation and real growth means raising interest rates to discourage bubbles from developing in the first place. Opponents of this interventionist view claim that bubbles are too difficult to identify when they are developing.

41. 23-41 Booms and Busts in Property and Equity Prices Opponents of leaning against bubbles used to argue that central banks should simply wait until the bubble bursts and only then react aggressively to limit the fallout on the economy by cleaning up the mess. The crisis of 2007-2009 undermined the rosy view that policymakers can sit back and clean up after a bubble bursts.

42. 23-42 Booms and Busts in Property and Equity Prices Central bankers still worry that interest rates are only a blunt tool and that pricking an asset price bubble could require rate hikes so severe that they would hurt the economy and reduce the likelihood of hitting a central bank's objective for inflation.

43. 23-43 Booms and Busts in Property and Equity Prices Today, the proper policy toolkit for addressing bubbles is not interest rates but the macroprudential regulatory tools that we discussed in Chapter 14. According to this view, bubbles are a major threat. The best result would be to adjust regulatory rules to inhibit intermediaries from extending such risky credit in economic booms.

44. 23-44 Booms and Busts in Property and Equity Prices This approach still depends on the foresight and judgment of regulators to limit the buildup of a menacing asset price bubble. Using interest rates to combat asset price bubbles now is more likely to be viewed as a backup approach for extreme circumstances, if the first-best methods of macroprudential regulation fail to limit a systemic threat.

45. 23-45 Making informed economic and financial decisions requires that you know the inflation rate. Focus on 12-month changes, especially measures that exclude food and energy. Stay informed about inflation so that you can adjust for it. Know the real interest rate you receive or pay and how much your real wage is changing.

46. 23-46 Deflation and the Zero Nominal- Interest-Rate Bound We noted before that nominal interest rates cannot be negative. There is a zero nominal-interest-rate bound. Investors can always hold cash, so bonds must have positive yields to attract bondholders. The risk of becoming caught in precisely such a predicament, where policymakers have no scope to lower rates further, has concerned central banks since Japan’s experience in the 1990s.

47. 23-47 Deflation and the Zero Nominal- Interest-Rate Bound Think about the consequences of a shock that depresses aggregate expenditure. The dynamic aggregate demand curve shifts to the left. Real output falls below potential - a recessionary gap. Monetary policymakers would normally react by cutting interest rates. This would increase spending, raise real output, and eliminate the output gap.

48. 23-48 Deflation and the Zero Nominal- Interest-Rate Bound What if, when the shock occurs, inflation is zero and the target nominal interest rate that central bankers control is close to zero? The decline in aggregate demand still drives real output below potential output. There is downward pressure on inflation. But when inflation falls, it drops below zero so that, on average, prices are falling. This result is deflation.

49. 23-49 Deflation and the Zero Nominal- Interest-Rate Bound Deflation isn’t necessarily a problem unless the shock that moves the economy away from its long-run equilibrium is big enough to drive output down to such a low level that policymakers can’t bring it back up. This is one of the central banker’s worst nightmares: A nominal interest rate of zero accompanied by deflation and real output that is below potential.

50. 23-50 Deflation and the Zero Nominal- Interest-Rate Bound The recessionary gap places further downward pressure on prices, driving deflation down even more. Because the nominal interest rate is already zero, policymakers cannot counter the worsening deflation by lowering it. The real interest rate rises, reducing spending, shifting the AD curve to the left. This expands the recessionary output gap. The result is deflationary spiral in which deflation grows worse and worse.

51. 23-51 Deflation and the Zero Nominal- Interest-Rate Bound Deflation makes it more difficult for businesses to obtain financing for new projects. Without investment there is no growth. Deflation, therefore, increases the real value of a firm’s liabilities without affecting the real value of its assets.

52. 23-52 Deflation and the Zero Nominal- Interest-Rate Bound There are ways to minimize the chances of this sort of catastrophe. Policymakers can choose from three strategies: 1.They can set their inflation objective with the perils of deflation in mind; 2.They can act boldly when there is even a hint of deflation; or 3.They can utilize the unconventional policy tools that we discussed in Chapter 18.

53. 23-53 Deflation and the Zero Nominal- Interest-Rate Bound The difficulties posed by the zero nominal- interest-rate bound arise only when central bankers have achieved their objective of low, stable, inflation. This suggests that central bankers should set their inflation objective high enough to minimize the possibility of a deflationary spiral.

54. 23-54 Deflation and the Zero Nominal- Interest-Rate Bound The consensus is that an inflation objective of 2 to 3 percent gives policymakers enough latitude to avoid the problems caused by deflation. Reducing the interest rate significantly and rapidly when faced with the possibility of hitting the zero nominal-interest-rate bound is “acting preemptively.”

55. 23-55 Deflation and the Zero Nominal- Interest-Rate Bound Dramatic actions of that sort are meant to ensure that the economy will recover before deflation can take hold. Finally, central bankers have at their disposal a range of unconventional policy tools that include: Policy duration commitments, Quantitative easing, and Credit easing.

56. 23-56 Deflation and the Zero Nominal- Interest-Rate Bound Central bankers are very reluctant to use such tools and, when used, are eager to exit as soon as improvements in the economy make it safe for them to do so. One reason is lack of experience in using them. Another is that policy exit may be difficult.

57. 23-57 Deflation and the Zero Nominal- Interest-Rate Bound Central banks prefer assets that are liquid and that do not tilt the playing field in favor of specific private borrowers. If a central bank faced sufficient losses, it might need to ask the government to replenish its capital. This could add to inflation expectations.

58. 23-58 The Evolving Structure of the Financial System Changes in financial structure will change the impact of monetary policy. As the nature of banking changes, we would expect the importance of this channel of monetary policy transmission to change along with it.

59. 23-59 The Evolving Structure of the Financial System The shift away from bank financing and toward direct financing in the capital markets means that the bank-lending channel of monetary policy because less important in the decades before the financial crisis. The decline of banks as a source of finance was accompanied by a corresponding rise in the importance of securities markets and shadow banks.

60. 23-60 The Evolving Structure of the Financial System The financial crisis that ended in 2009 has interrupted the trend toward direct finance: Securitization has declined or slowed since 2006. The future of GSEs is highly uncertain, with many observers calling for them to be dismantled.

61. 23-61 The Evolving Structure of the Financial System How the post-crisis financial system will change will depend on how regulatory policy evolves in coming years as regulators seek to prevent another crisis or minimize its potential impact. Effective securitization must avoid leaving concentrations of securitized assets on the balance sheets of intermediaries that make them vulnerable to collapsing asset price bubbles.

62. 23-62 The Evolving Structure of the Financial System Macroprudential regulation will tend to slow the future pace of securitization, especially compared to the boom years preceding the financial crisis. The changing effectiveness of conventional monetary policy likely will require central bankers to update their unconventional policy tools, too.

63. 23-63 The Evolving Structure of the Financial System As the characteristics of money, banks, and loans evolve, we will all adjust: How we pay for our purchases, How we hold our wealth, and How we obtain credit.

64. 23-64 By early 2010, the Fed had presented the public with considerable detail about the tools that it would use to tighten monetary policy and exit from the unconventional policies that it had implemented during the financial crisis of 2007-2009. The large size and unusual composition of the Fed’s post-crisis balance sheet meant that the procedures for tightening would be different than in normal periods.

65. 23-65 By raising the interest rate that it pays on reserves, the Fed is able to tighten policy without shifting its balance sheet. When the Fed tightens, see if you can detect the shift by examining its assets and liabilities. These are reported each week in Federal Reserve Statistical Release H.4.1.

66. Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Modern Monetary Policy and the Challenges Facing Central Bankers Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin End of Chapter Twenty-Three