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Summary IBF Material Week 7 - Central Banking and Shadow Banking
Schasfoort (2021a), Schasfoort (2021b), Schasfoort (2021c), Yellen (2016), Gabor & Vestergaard (2016), and Lecture W7
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W7 - Lecture prepOctober 12, 2022 11:43 AM
Title:
Yellen (2016): Opening Remarks: The Federal Reserve’s Monetary Policy Toolkit
WI this report about?
• This report reflects on lessons learned by the Fed from the crisis and their potential for
future monetary policy
• Her focus is about the policy tools needed for a resilient monetary policy
framework
○ Likely need to retain the policy tools developed to promote recovery
• Current economic situation and outlook±
• US economic activity continues to expand (lower unemployment, yet low inflation)
but:
○ Soft investments
○ Soft foreign demand
○ Appreciated dollar restraints exports
• Expected:
○ moderate growth of GDP
○ Decreasing unemployment
○ Inflation rising to 2%
• Consequences:
○ Gradual increases in the Fed funds rate may be appropriate to sustain
employment and inflation (conditional on continuation of these
developments)
▪ The economy is constantly hit by shocks, so it rarely evolves as
predicted.
▪ 70% probability that fed funds rate will remain between 0-3.25 at the
end of 2017, and 0-4.5% by the end of 2018.
W was the pre-crisis • Pre-crisis toolkit:
toolkit of the Fed? • Simple but effective back then
• Tools:
○ Open market operations (OMOs) to manage the amount of reserve balances
available to banking sector
▪ Effect:
W was the objective
of OMOs by the Fed
□ changes in federal fund market interest rates (and in the upper
before the crisis? bound for interbank market)
Because aggregate level of reserves was small (~$45 bill),
even small OMO had large effects on fed fund rates
□ Transmission to other short-term interest rates
W were their effect? eventually to long-term interest rates (liquidity-premium
theory), which shaped overall financial conditions,
inflation and economic activity
W was the advantage ▪ Advantages: FED needed only a relatively small balance sheet (just to
of OMOs? supply enough US currency to meet demand)
▪ Disadvantages (revealed by the crisis):
W is the disadvantage
of OMOs? (why are □ Inability to control de fed funds rate once reserves were no
they ineffective longer relatively scarce
now?) banks had to be provided with more reserves so that
credit kept flowing to households and businesses (with
questionable success rates)
Difficult to sustain as the increase in liquidity (reserves)
would push down the fed funds rate (below FOMC's
target)
◊ Fed had to engage in asset purchases and other
tools. Anyhow, it was not enough…
□ Inability to generate substantially more accommodation of fed
W is a limitation of
Banking Page 54
, □ Inability to generate substantially more accommodation of fed
W is a limitation of
OMOs? fund rates beyond (near) zero
Zero lower bound illustrates that investors have an
outside option to bonds, cash.
W new tools did the • Expanded toolkit:
Fed adopt after 2008? • Possible to pay interest on bank's excess reserves (IOER) balances
(4 tools) ○ Allows to break the strong link between the quantity of reserves and the
WI the effect of level of the federal funds rate
IOER? ▪ Allows Fed to control short-term interest rates when reserves are
plentiful (by putting upward pressure on market interest rates banks
charge)
○ Generally fed funds rates are lower than IOER rates (because only depository
institutions can access IOER rates), which demands complementary
measures…
• Other tools to create a more effective floor under short-term interest rates:
WR ON RRP? ○ Overnight reverse repurchase agreement (ON RRP): eligible counterparties
may invest funds overnight with the Federal Reserve at a rate determined by
the FOMC.
▪ Available to more institutions (i.e.: money market funds, government-
WI the aim of RRP? sponsored enterprises, broker-dealers and depository institutions)
▪ Discourages institutions to lend at a rate much lower than that of ON
RRP
WI QE? WI their goal? ○ Large scale asset purchases (QE): purchases of treasury and MBS in the open
market to influence long-term borrowing rates.
WI forward guidance? ○ Increasingly explicit forward guidance: (i.e.: announcing that they intend to
WI its goal? keep short-term rates longer than expected, announcing the size and scope
of future asset purchases) to influence long-term borrowing rates.
○ Effects:
WR the effects of
these 4 tools? ▪ Spur growth in demand for goods and services
▪ Prevent inflation from falling below target
▪ Lower unemployment rate
HD IOER and QE
complement each • Ability to pay IOER and asset purchases complement each other: asset purchases
other? expand Fed reserves. If they cannot control the interest paid in the face of
extensive supply, it could have gotten out of control.
R these new tools • Where do we go from here?
here to stay? • The ability to pay IOER is here to stay because of the expanded assets held by the
Fed since the crisis and because of the tool it can be for fine-tuning liquidity in the
economy via monetary policy.
• Forecasts estimate a Fed funds rate of ~3% in the long run (as opposed to 7%, the
Why (not)? average over 1965-2000)
○ Less scope for interest rate cuts as monetary policy tool
○ Reasons:
▪ Lower expected fed funds reflect success of the Fed to anchor
inflation expectations
▪ Decline in long-run neutral real rate of interest due to slower growth
of working-age population, smaller productivity gains in advanced
countries, decreased propensity to spend (c1) after the crisis and
scarce attractive capital projects worldwide.
□ long-run neutral real rate of interest: inflation-adjusted short-
term interest rate consistent with keeping output at its
potential on average over time
This implies believing that there is a NAIRU, though this
contradicts Minsky's theory of instability?
D the low forecasted ○ Does such low Fed funds rate impair policy effectiveness?
Fed funds rate impair ▪ In the awakenings of the past 7 crises, the Fed funds rate was much
policy effectiveness?
above the level consistent with the economy operating at potential
( ) in the long-run (a.k.a.: tighter-than-normal stance of policy)
□ Tighter-than-normal stance reflected: overuse of labor and
elevated inflation pressures
Banking Page 55
, elevated inflation pressures
□ Large portion of the Fed funds rate cut was to undo the earlier
tighter-than-normal stance of monetary policy
□ If this was the reason again, then the rate would be again at a
higher rate than the ideal one, giving room for conventional
policy interventions (lowering the rate)
▪ Simulations suggest that these 3 new tools would be enough to
generate conditions as good as those in a scenario in which the zero
policy rate did not constraint further decrease of the Fed funds rate,
unless the recession were to be unusually severe and persistent.
□ This simulations may be overoptimistic:
Simulations overstate effectiveness of forward guidance
and asset purchases in low long-term interest rates
environment
Simulations might overstate initial Fed funds rate (might
be lower than 3%)
Relying to heavily on this non-traditional tools can be
counterproductive: they might encourage excessive risk-
WI the new taking and undermine financial stability
responsibility of CB • Fed still needs to focus on financial stability in addition to its dual mandate
since 2008? (inflation and employment)
• New measures might be needed in the future for specific economic conditions
○ Tools other central banks have implemented:
▪ Purchase of a broader range of assets
▪ Rising inflation target of 2%, or using frameworks as price-level or
nominal GDP-targeting
• Fiscal policy is an important tool to deal with recessions:
○ Works to enhance the cyclical stability of the economy (reference to
Minsky?)
• We need to explore ways to raise productivity growth.
○ Stronger productivity growth tends to raise average levels of interest rates,
thus improving living standards as well as giving more scope for Fed's
conventional policy
○ Possible ways: improving human capital (education system and worker
training, promoting R&D), promoting K investment, limiting regulatory
burdens while protecting important economic, financial, and social goals
• Conclusion:
• These new measures are likely here to stay
• Despite lower estimated future Fed fund rates, monetary policy is likely to be able
to respond effectively thanks to these new measures
Schasfoort (2021): "Why Europe Invented Central Banking" (changed names…)
WI a CB? • Central Bank (CB): "a national bank that provides financial and banking services for its
country’s government and commercial banking system, as well as implementing the
government’s monetary policy and issuing currency."
WR the 3 necessary
• Necessary features:
features of a CB? ○ Take deposits
○ Provide credit
○ Have a national-level scale
WR the goals? • Supposed to defend price stability and financial stability. In the US, the Fed also
aims to maintain full employment.
• Steps towards central bank invention:
• In 13th century medieval Europe, different political institutions (i.e.: monarchs)
Y were banks created had different currencies, though due to variability of value and risks commerce
in medieval Europe? depended on the balances held at emerging banking institutions
○ Problem: The economy was very sensitive to these institutions (monarchs or
worse, banks) failing
Y was Casa di San • First attempt: Casa di San Giorgio (1st gov't owned bank) was created in 1407 in
Giorgio not a CB?
Genoa
Banking Page 56
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