ProfESSOR Anne sibertSpring 2014

Monetary policy in A CRISIS

The balance sheet of a generic central bank

ASSETS LIABILITIES

Securities Currency in Circulation

Loans and Related Operations Financial Institutions Balances

Other Assets Other Liabilities

Net Worth

During Normal Times: Securities

A central bank’s securities might be its holdings of its government’s bonds.

The Federal Reserves buys and sells U. S. Treasury bonds and bills as part of its monetary policy and it holds U. S. Treasury bonds and bills.

The Maastricht Treaty prohibits the Eurosystem from buying government debt in the primary issuer market and before the recent crises it was generally believed that buying government securities in the secondary markets was a violation of the spirit of the Treaty. Therefore, before the crisis it did not hold securities for monetary policy purposes.

Repos and Reverse Repos

A financial institution engages in a repurchase agreement or repo when it sells securities to a counterparty and then agrees to repurchase them from the same counterparty at a specified date and time: this is equivalent to collateralized borrowing.

A financial institution engages in a reverse repurchasing agreement or reverse repo when it buys securities from a counterparty and then agrees to resell them to the same counterparty at a specified date and time: this is equivalent to collateralized lending.

Clearly, when a financial institution conducts a repo operation with another financial institution, that other financial institution is conducting a reverse repo.

Loans and Related Operations

Central banks often make monetary policy buy borrowing and lending.

In normal times, most of their loans are short-term collateralized loans and the collateral offered is high quality, say, government debt.

They also engage in reverse repos. When they do this they temporarily securities. These securities are also high quality, say government debt.

The Fed, viewing things from the counterparty’s point of view, refers to its reverse repos as repos. Thus, what the ECB calls reverse repos, the Fed calls repos.

Lender of Last Resort in Normal Times

Central banks act as the lender of last resort to solvent but illiquid financial institutions. They usually charge above-market interest rates.

The Federal Reserve makes short-term loans against high-quality collateral through its discount window. The interest rate is called the discount rate. There is a stigma attached to borrowing from the discount window.

The ECB makes short-term loans against high-quality collateral at its marginal lending facility.

Other Assets

Probably for most central banks the most important component of Other Assets are their assets denominated in foreign currency: their foreign exchange reserves.

Many central banks, especially those with fixed exchange rates, buy and sell their foreign currency reserves with the intent of managing the value of their domestic currency.

Other assets can also include the central bank’s premises and its gold holdings.

Currency in Circulation

The first item on the liability side is currency in circulation. This is the value of the notes and coins held by the private sector.

Under a gold or silver standard, the outstanding currency was a liability of the central bank as the central bank offered to redeem this money in gold or silver.

For modern central banks the outstanding currency is no longer a liability as the central bank no longer offers to redeem it for anything.

The increase in the real value of the currency in circulation is actually an increase in the central bank’s net wealth. Hence, it is an increase in government revenue. This tax revenue is called seiniorage.

Financial Institutions Balances

Financial institutions have accounts at the central bank.Just as an individual’s current account at a particular

bank is a liability of that bank, financial institution’s balances at the central bank are the liability of the central bank.

Many central banks require depository institutions to hold a fraction of their own deposits in deposits at the central bank. The requisite fraction is called the reserve requirement.

The Fed calls this component Depository Institutions Balances. The ECB calls it Counterparties’ Deposits.

In normal times, most financial institutions do not like to hold money at the central bank as they can make more income investing or lending their money elsewhere.

Other Liabilities and Net Worth

When a central bank engages in a repo, it sells a security and then incurs an obligation to buy it back. This obligation is a liability.

On the liability side of the Eurosystem’s balance sheet are repos. The On the liability side of the Fed’s balance sheet are reverse repos. This is because the Fed is using is using reverse terminology.

The difference between a firm’s assets and liabilities is its net worth or capital. Since currency in circulation is not actually a liability, a central bank’s net worth is really its assets minus its liabilities other than currency in circulation. As a result, central bank’s can have a negative net worth, as conventionally defined.

The Fed and the Eurosystem in Normal Times

Assets Liabilities

Securities Currency in Circulation

Loans and Repos

Depository Institutions’ Balances

Other Assets Other Liabilities including Reverse Repos

Net Wealth

Assets Liabilities

Loans and Reverse Repos

Currency in Circulation

Other Assets Counterparties’ Balances

Other Liabilities including Repos

Net Wealth

Federal Reserve System

Eurosystem

In normal times, the Fed conducted open-market operations

to expand the money supply by Buying US Treasuries from depository institutions and paying

for them by crediting the buyers’ accounts at the Fed. This permanently increases an asset (securities) and a liability (depository institutions’ deposits).

Conducting a repo: Temporarily buying securities and paying for them by increasing the purchasers’ accounts at the Fed. This temporarily increases an asset (repos) and a liability (depository institutions’ deposits).

to contract the money supply by Selling US Treasuries to depository institutions and collecting

payment for them by debiting the buyers’ accounts at the Fed. This permanently decreases an asset (securities) and a liability (depository institutions’ deposits).

Conducting a reverse repo: Temporarily selling securities and paying for them by increasing the purchasers’ accounts at the Fed. This temporarily increases a liability (reverse repos) and decreases a liability (depository institutions’ deposits).

In normal times the ECB

Mainly conducted monetary policy through its main refinancing operations: reverse repos and repos.

Note that for the Fed, buying securities increased the size of its balance sheet

Conducting what the Fed calls a repo and the ECB calls a reverse repo temporarily increases the size of the central bank’s balance sheet.

Conducting what the Fed calls a reverse repo and the ECB calls a repo has no effect on the size of the central bank’s balance sheet.

Measures of money in the United states

• Base money is currency in circulation, currency held in the vaults of banks and reserves held by depository institutions at the central bank. It is sometimes called high-powered money and it is called narrow money in the United Kingdom.

• Base money is the amount of money produced directly by the government.

• M1 is currency in circulation, travellers’ checks and checkable deposits.

• M2 is M1 plus other accounts that can be readily converted into M1 without significant loss of principal.

Relationship between currency and m1

• Depository institutions hold cash at the Federal Reserve. This is the depository institutions balances component of the Fed’s balance sheet. They hold three types of balance.

• Required reserve balances• Contractual clearing balances• Excess reserves

Required reserves

In the United States depository institutions must hold a fraction of all their transactions deposits in the form of vault cash or as reserves at a Federal Reserve bank. This fraction, the reserve requirement, is set by the Board of Governors.

As of 2006 the reserve requirement was about ten percept on most accounts.

The United Kingdom has no reserve requirement. The requirement in the Eurozone is one percent.

In the United States depository institutions can use sweep accounts to avoid reserve requirements.

Contractual clearing balances

Depository institutions can hold an agreed upon amount of additional balances at the Fed called contractual clearing balances.

These balances earn “interest” that can be used to pay for the Fed services that it uses. However, if these balances fall short of the agreed upon amount then the bank must pay a penalty fee.

Excess reserves and Interest on reserves

If a bank is uncertain about its cash needs it can hold additional buffer reserves at the Federal Reserves called excess reserves.

The Federal Reserve Banks pay interest on required reserve balances. This is intended to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions.

Since 1 Oct 2008 the Fed pays interest on excess balances. This rate is also determined by the Board and gives the Federal Reserve an additional tool for the conduct of monetary policy.

The monetary base and the money supply

Suppose that banks hold a fraction R of their deposits as reserves and lend out the rest.

Suppose that the central bank increases the money supply by 100 million currency units.

The market participants take the 100 million units to the bank (call this Bank A) and deposit them. The bank lends keeps a fraction R as reserves and lends out a fraction R.

What happens nextWhat happens nextChange in Bank A’s Balance Sheet

Change in Bank A’s Balance Sheet

When Bank A loans out 100 x ( 1 – R) units, the borrowers deposit this amount into Bank B. Bank B holds a fraction R as reserves and lends out a fraction 1 - R

Change in Assets

Change in Liabilities

Reserves + 100 x R million

Deposits + 100 million

Loans + 100 x (1 – R) million

Bank a

What happens nextWhat happens nextChange in Bank B’s Balance Sheet

Change in Bank B’s Balance Sheet

When Bank B loans out 100 x ( 1 – R)2 units, the borrowers deposit this amount into Bank C. Bank C holds a fraction R as reserves and lends out a fraction 1 – R.

Change in Assets

Change in Liabilities

Reserves + 100 x R(1 – R) million

Deposits + 100 x (1 – R) million

Loans + 100 x (1 – R)2 million

Bank B

Change in the money supply

• The change in the money supply is then the original increase 100 million deposited at Bank A, the 100 x (1 – R) million deposited at Bank B, the (1 – R)2 million deposited at Bank C and so on.

• Thus, the total increase is 100 x [ 1 + (1 – R) + (1 – R)2 + … ].

• If |x|< 1, then 1 + x + x2 … = 1/(1 – x). Thus, 1 + (1 – R) + (1 – R)2 + … = 1/[1 – (1 – R)] = 1/R.

• If banks hold 10 percent of their deposits as reserves, then a 100 million unit increase in currency increases the money supply by 1000 million units.

• If banks hold 20 percent of their deposits as reserves, then a 100 million unit increase in currency increases the money supply by 500 million units.

The money multiplier

The total increase in the money supply brought about by the central bank’s increase in the money supply through open market operations depends on the amount of reserves that banks want to hold. Note that R depends on economic conditions and varies over time.

The increase in the money supply brought about by a one unit increase in base money is called the money multiplier.

Federal funds market

The federal funds market is a US interbank market for immediately available funds. Loans are uncollateralised and are usually for overnight.

The participants who borrow in the market are depository institutions that need to meet reserve requirements.

The Federal Reserve can affect the supply in the market with open-market operations: changing the amount of securities and repos that it holds.

It can also affect supply by lending at its discount window.

Discount window

• The discount window is the mechanism whereby banks receive short-term collateralised loans from the central bank.

• In the United States discount window borrowing is viewed as lender of last resort borrowing and there is a penalty interest rate.

• In the United States the rates are set by the Federal Reserve Banks with the approval of the Board of Governors.

• If the discount rate is below the federal funds rate then borrowing is increasing in the spread between the federal funds rate and the discount window.

• In non-crisis times the Fed discourages repeated borrowing at the discount window.

• Since January 2003 the discount rate has been above the fed funds rate to discourage borrowing.

Open market operations

• The Fed conducts two types of open market operations: outright transactions and repurchase or reverse repurchase transactions.

• In an outright transaction the trading desk buys or sells a security to a dealer. In normal times this security is a previously issued government security.

• In a repurchase transaction the trading desk buys securities from a dealer and the dealer agrees to buy them back at an agreed upon later date. This is equivalent to a collateralised loan. There are also reverse repurchase transactions where the trading desk sells securities and agrees to buy them back.

Open market operations

When the Fed buys securities from a dealer it pays for the security by crediting the reserve account of the dealer’s bank at a Federal Reserve Bank. [Recall: an increase in a liability is a credit.]

The Fed’s assets increase and depository institutions’ reserves increase.

When the Fed sells securities to a dealer it is paid by debiting the reserve account of the dealer’s bank at a Federal Reserve.

The Fed’s assets decrease and depository institutions’ decrease.

The supply of reserves

• The supply of reserves comes through two channels:• Open-market

operations (non-borrowed reserves)

• Borrowing at the discount window

• This is upward sloping if the discount rate is below the fed funds rate and vertical otherwise

• The supply of reserves

Federal funds rate

The demand for reserves

The demand for excess reserves is decreasing in the spread between the federal funds rate and the interest rate paid on excess reserves (this is the opportunity cost of holding reserves)

The fed funds market

Federal funds rate

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Targeting the Fed funds rate

The Federal Open Market Committee of the Federal Reserve System makes monetary policy by choosing a target federal funds rate.

The choice of a target rate will imply a level of total reserves.

If the money multiplier is relatively stable then this will provide a link between reserves and M1 and hence a link between the interest rate and M1.

Federal funds targetting

Since 1988 the Federal Open Market Committee of the Federal Reserve has primarily made monetary policy by selecting a policy interest rate: the target federal funds rate.

The Federal Reserve Bank of New York, acting as agent for the FOMC, conducts open-market operations to attain this targeted rate.

Beginning in 1994, the FOMC began announcing changes in its policy stance.

In 1995 the Fed began to explicitly state its target level for the federal funds rate

Attaining the target rate

• In usual times the Fed attains its target by offsetting transitory changes in depository institutions’ reserves.

• If it wants to increase these reserves it engages in repurchase agreements (“repos”). These operations are equivalent to short-term collateralised loans but technically they are arrangements where the Fed buys securities in exchange for reserves and agrees to subsequently resell them.

• The Fed’s terminology is unusual. A repo is an agreement to sell securities and then to buy them back at a later date. The Fed is viewing things from its counterparty’s point of view.

• As a result, the Fed’s balance sheet temporarily expands: the monetary base component of its liabilities rises, as does the repo component of its assets

The ECB’s refi rate

Most of the liquidity that was provided to the Euro Area banking system was provided through the main refinancing operations, which are reverse repos with a maturity and frequency of a week.

The ECB’s main policy rate, the refinancing or refi rate, is not a target as is the Fed’s, but rather the interest rate on its main refinancing operations. In addition to its short-term main refinancing operations, the ECB also carried out longer-term operations with a monthly frequency and a three-month maturity.

The refi rate is also the mininum rate in a variable-rate tender. While not precisely a target, the ECB seeks to influence

EONIA, an interest rate for uncollateralized overnight euro-denominated loans in the interbank market.

Monetary policy in the crisis

• Unfortunately for the FOMC, as well as other monetary policy committees around the world, by the time the global financial crisis started in earnest in September 2008, policy interest rates were already quite low and there was little scope to reduce them further.

• After the onset of the credit crisis in August 2007 the FOMC had cut its policy interest rate sharply. As seen in Figure 2 below, the federal funds target rate was 2.0 percent in September 2008; by December of that year it had been reduced to the range 0 - .25 percent.

The Fed cut rates aggressively

The ECB cut rates

Interest rates were near zero

As market participants can always hold currency, which pays an interest rate of zero, central banks had little further room to manoeuvre once their policy rates were at or near zero.

Negative interest rates are possible -- the government could require that currency be stamped for a fee to remain legal tender or it could abolish it altogether.

But, this is probably prohibitively costly to administrate or politically infeasible.

Early on in the crises the Fed and the ECB had driven their policy rates as low or close to as low as they could get without having the desired effect of producing the necessary stimulus.

Quantitative easing

Another idea: Instead of announcing a policy interest rate, the central bank could simply engage in further expansionary open-market operations, selling home-currency denominated securities to increase the monetary base.

This idea, referred to then as quantitative easing, was tried in Japan in 2000.  Unfortunately, quantitative easing did not work well there and theory

suggests that simply increasing the monetary base is not effective when interest rates are near zero.

In such a scenario the private sector is already holding as much money as it wants for transaction purposes and it perceives money and low-interest-bearing government securities as good substitutes. It is in a liquidity trap.

An increase in the monetary base accompanied by an equal-sized increase in central bank holdings of low-interest-bearing government securities, therefore produces little change in the behaviour of households and firms and hence, little change in nominal variables.

With little change in nominal variables, even unanticipated monetary policy cannot produce much change in real variables. Conventional open-market operations are of little effect in a low-interest-rate environment.

Quantitative Easing

The Fed began its first round of quantitative easing, QE1, in November 2008 and this lasted until March 2010.

The second round, QE2, began in November 2010 and lasted until June 2011.

The third and current round, QE3, began in 13 September 2012. Under QE3 the Fed purchases USD 40 billion of mortgage-backed securities and USD 45 billion of U. S. Treasuries each month. It is the proposed tapering of these purchases that is creating the current anxiety in global financial markets.

The Fed more than quadrupled its balance sheet

Qualitative Easing

In an attempt to free up illiquid markets and deal with failed financial institutions, central banks began to explore more unusual types of monetary policy.

In the United States, the Federal Reserve bought the debt of Fannie Mae, Freddie Mac and the Federal Home Loan banks, as well as mortgage-backed obligations guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. It also engaged in other crisis-related activities such as the creation of the Maiden Lanes I, II and III vehicles.

Balance Sheet of the Fed

In 1000 millions of dollars, source: Federal Reserve Board

Source: Federal Reserve

Operation twist

• If long rates could be lowered, this would boost demand directly, and also indirectly, by boosting the value of long-dated real assets such as equity, land and real estate and weakening the exchange rate.

• Desperate for further ideas, on Mar 2009 the Federal Reserve announced a programme under which it purchased $300 billion of Treasury securities by Oct 2009. These included securities across the maturity spectrum, but most were of intermediate maturity.

• The idea of the Fed swapping debt of different maturities to change the yield curve is not new: it was tried briefly, with little obvious success, in the 1960s and was called Operation Twist.

• Unfortunately, as long as markets are efficient, economic theory predicts that such a move should have no impact.

• The government has a monopoly on issuing money; hence, its price depends on its supply. But, any household, firm or institution can issue debt and any debt held is one party’s asset and another’s liability. Its net supply is always zero in equilibrium and its price does not depend on the amount issued by any particular party.

Maturity structure of Fed’s balance sheet

Effectiveness

• None of the Federal Reserve’s actions since the crisis began have yet had an obvious direct stimulative effect on the economy, although the qualitative easing has helped indirectly by increasing liquidity and assisting in the restructuring of the banking system.

• The massive increase in the Federal Reserve System’s balance sheet featured an increase in the monetary base, but most of this was due to an increase in banks’ excess reserves. Banks are holding most of the increase in the money supply as deposits at the Federal Reserve.

M1 and M2

inflation

Crisis Monetary Policy at the ECB

• During the crises the ECB focused more on restoring order to dysfunctional markets than on quantitative easing. As a result, the Eurosystem’s balance sheet has not mushroomed to the same extent as that of the Federal Reserve System’s.

• However, the ECB moved to providing unlimited amounts of liquidity at its refi rate, it massively expanded the set of securities that it accepted in its open market operations and it introduced LTROs at attractive rates, including two three-year LTROs with full allotment announced on 8 December 2011.

• Between 3 August 2007 and the summer of 2012, total assets nearly tripled from about EUR 1.2 trillion to about EUR 3.1 trillion.

• The ECB has since allowed its balance sheet to contract and as of 22 November 2013 total assets amounted to EUR 2.3 trillion, almost twice the pre-crises size.

The Eurosystem’s Assets

Changing composition of Eurosystem assets

On 6 July 2009 the ECB initiated the Covered Bond Purchase program, allowing the Eurosystem to purchase securities outright for the first time. The program was discontinued after one year and a second program was initiated in November 2011.

On 9 May 2010, it announced its Securities Market Program (SMP) under which it would purchase Euro Area government bonds outright in secondary markets as part of the financial support scheme for heavily indebted Euro Area countries.

On 2 August 2012 it initiated its outright monetary transactions (OMTs) program of sterilized purchases of short-term sovereign bonds of countries that have requested assistance from the EFSF/ESM.

Compared with the Federal Reserve, the Eurosystem’s outright purchases are still a very small part of its assets. As of 29 November 2013 the Eurosystem had about EUR 184 billion of this debt outstanding on its books and about EUR 57 billion of debt from the Covered Bond program. The evolution of the Eurosystem’s assets is seen in the next slide.

Composition of Eurosystem assets

Exit strategies

The Fed’s exit problem is clear: on its asset side it has about USD 1.4 trillion in relatively illiquid mortgage-backed securities that it would probably like to hold on to until their maturity or at least the foreseeable future and on its liability side it has a mountain – about USD 2.5 trillion – of depository institution’s reserves. The problem of the Eurosystem is similar, if smaller in magnitude.

Despite the size of the reserves on both central banks’ balance sheets, the spectre of the excess reserves suddenly vanishing and fuelling rampant inflation can be banished.

As long as the interest paid on reserves is high enough, the banks will be willing to hold their funds at the central bank. Alternatively, either central bank can always increase its reserve requirement.

There will be no excess inflation in either area unless the central bank chooses to allow it.