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Normalizing Monetary Policy after the Great Recession AndrĂŠ Kurmann School of Economics LeBow College of Business Drexel University

32nd GIC Monetary and Trade Conference Drexel University, April 16 2014

Introduction • U.S. monetary policy changed dramatically during the recent financial crisis and ensuing ‘Great Recession’. • When and how will monetary policy return to normal? • Key message of talk: The Fed is unlikely to return to normal. 1.

The Fed introduced new policy tools during the crisis and is likely to use them again in the future if need arises.


There are several issues with reducing the balance sheet back to precrisis levels.


The Fed is experimenting with a new operating framework that allows it to manage the balance sheet independently of the policy rate.


The Fed’s balance sheet expansion

Source: Federal Reserve Bank of Cleveland (2014). 3

The Fed’s balance sheet expansion • Lending to financial institutions and liquidity programs •

Generally considered a success: kept key parts of financial system from collapsing, and unwinding generated profits for taxpayer.

Moral hazard implications are potentially important but hard to quantify.

• Large-scale asset purchases (LSAPs) •

Research supports effectiveness of LSAPs in lowering asset prices and improving macro conditions (although effects are subject to large uncertainty).


Source: Williams (2013)


The Fed’s balance sheet expansion • Potential costs and risks of LSAPs ‣

May impair market functioning

May encourage excessive risk-taking in search for yield

May decrease Fed profits, implying political costs

May have destabilizing effects during exit

• Observation 1 ‣

Fed’s new policy tools are generally considered a success with costs that are hard to quantify.

Fed is likely to use these tools again in the future if need arises.


Conventional monetary policy going forward •

Short-term interest rates are expected to lift off from zerolower bound in 2015.

This policy tightening will almost surely take place in environment of abundant liquidity. ‣

Excess reserves projected at US$ 3 trillion by beginning of 2015.

How to manage short-term rates in environment with abundant liquidity?


Projection of Fed assets and reserves

Source: Gagnon and Sack (2014)


The Fed funds market • Fed’s main policy instrument remains target for Fed funds rate. ‣

Interest rate on overnight loans between depository institutions

Fed funds rate targeting primarily through controlling supply of reserves.

• Prior to crisis, Fed funds rate represented marginal cost of lending for depository institutions. ‣

Relatively small changes in supply of reserves had meaningful effects.

• With abundant liquidity, Fed funds rate targeting is no longer effective.


The Fed funds market • Fed funds rate would become effective again only if large amounts of liquidity are drained quickly. • Large sales of Fed’s treasury and MBS portfolio could destabilize market, causing important market distortions. • Longer-maturity treasuries and MBS do not necessarily have the same liquidity properties as reserves. • Observation 2 ‣

Within existing operational framework, there are several issues with reducing the Fed balance sheet back to pre-crisis levels. 10

New operational tools • Interest on reserves (IOR) ‣

In October 2008, Fed started paying interest on reserves.

No arbitrage implies that Fed funds rate and other short-term rates should remain close to IOR.

In practice, Fed funds rate and other short-term rates trade below IOR. -

Reflects limits to arbitrage because of ineligibility of certain large lenders to receive IOR; limits on trade size; and higher balance sheet costs (e.g. FDIC fees).

• Fed’s ability of controlling short-term rates through IOR is limited. ‣

Issue could become more important away from zero lower bound.


Short-term rates during the financial crisis

Source: Gagnon and Sack (2014)


Short-term rates 2009-2013

Source: Gagnon and Sack (2014)


New operational tools (continued) • Overnight reverse repurchase facility (RRP) ‣

Fed sells security to financial intermediary in exchange for reserves, promising to buy security back at fixed price in the future.

Available to broader set of market participants, including primary dealers, money market funds, and GSEs.

If used as full-allotment facility, would put firmer floor on overnight lending rates and therefore on marginal cost of lending in financial system.


Advantages of RRP • Shifts focus of monetary policy directly on control of short-term rates. • Reflects that large portion of credit creation is intermediated not through depository institutions but through broader set of financial market participants. • Allows Fed to manage balance sheet independently while maintaining better control of short-term rates than with IOR. • Helps financial institutions in fulfilling new regulatory requirements on liquidity coverage ratios.


Towards a new operating framework • At September 2013 meeting, FOMC authorized NY Fed to start operational testing of RRPs with extended set of counterparties ‣

Current maximum bid of $7 billion per counterparty at 5 basis points.

Daily volume around $100 billion.

• Issues if RRP were to become new operating framework. ‣

RRP is essentially an extension of IOR to broader set of counterparties. But then, what should IOR be?

How should the Fed communicate new framework to markets?

Fed would need to maintain large balance sheet of treasuries.

• Observation 3 ‣

Fed is experimenting with a new operating framework that allows it to manage the balance sheet independently of the policy rate.


Conclusion • The Fed’s monetary policy is unlikely to return to normal. • This is on top of other significant changes affecting the Fed. ‣

Move towards greater transparency in policy making.

New, important responsibilities in financial supervision.

• Thank you!


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