Monetary Policy Transmission
Mechanism
CTP Training Program
Macroeconomic Management and Financial Sector
Issues
Presenter
Tao Wu
Content Outline
• General Issues about Monetary Policy
Objectives: What monetary policy can and cannot
do.
Choice of policy instruments: direct or indirect ?
Choice of operating target: interest rate or monetary
aggregates?
• Transmission Mechanism: How does monetary
policy work?
Interest rate, Credit, Asset price, Exchange rate
• Recent Monetary Policy Issues: The .
Federal Reserve’s Unconventional Monetary
Policy Operations
2This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF Institute courses. Any reuse requires the permission of the IMF
Institute.”
What Monetary Policy Can and
Cannot Do
What Monetary Policy Can and Cannot Do
“We are in danger of assigning to monetary
policy a larger role than it can perform, in
danger of asking it to accomplish tasks
that it cannot achieve, and, as a result, in
danger of preventing it from making the
contribution that it is capable of making.””
— Presidential address of Milton Friedman at the 80th
Annual Meeting of the American Economic Association,
1967.
What Monetary Policy Can and Cannot Do
• Long-run effects vs. Short-run effects
Monetary policy may be effective in short run, but its
effects in determining the real economic growth or
employment in long run are almost negligible.
• The best way for monetary policy to promote long-
run economic growth is to ensure price stability.
Pricing system works more efficiently to allocate
resources when prices are on average stable;
To avoid distortions caused by the interaction of
inflation and a tax system based on the assumption
that prices are stable.
What Monetary Policy Can and Cannot Do
• Central banks cannot have any substantial
effect on trend growth in output or trend growth
in employment.
policies by government that can have a material influence on
both: education, human capital, technological innovations,
taxation, protection of private property rights, etc.
• However, by keeping inflation low and stable,
central banks can operate monetary policy with
the objective of keeping actual output and
employment as close as possible to the trend of
potential output and employment.
Monetary Policy: Objectives
• Price Stability (low and stable inflation);
• Reduced Volatility of business cycles;
• Central banks may also be concerned about
Interest rate stability and financial market stability;
Exchange rate stability.
Monetary Policy: Objectives
• What do we mean by price stability?
• Prices are not changing on average.
However, individual prices may rise or fall.
• Why not zero percent inflation?
Upward bias in measured inflation
Reduce the risk of deflation (to avoid a “liquidity
trap”–zero bound on nominal interest rates).
Time
GDP
Central Bank may also be able to
reduce volatility of business cycles
What Monetary Policy Cannot Do: Lessons
from the Phillips Curve
• Is there a trade-off between inflation and
unemployment?
• The Phillips curve:
Williams Phillips (1958), using 97 years of the
. data, showed a tradeoff between
unemployment and nominal wage growth.
Data for the US up to 1969 showed the same.
What happens if a central bank tries to exploit
continuously the short-run trade-off and
wants to persistently push the unemployment
rate below its potential level?
Phillips Curve in the .: 1960 - 2007
Trade-offs between Inflation and Unemployment
• For instance, a central bank may decide to
increase money supply or keep interest rates low,
thereby pushes unemployment rate below its
potential level at the price of a higher inflation,
thus there seems to be a trade-off in short run.
• However, inflation surprises cannot stimulate
short-term employment very often.
• In the long run, economic agents will adjust their
inflation expectations accordingly. Therefore,
discretionary policies will most likely end up with
higher inflation but no lower unemployment.
Trade-offs between the Volatilities of
Inflation and Unemployment
• Assume that the objective of a central bank is
to minimize
where is the target unemployment rate;
is the target inflation rate;
is the inflation-aversion parameter.
• Central banks can trade more unemployment
or output volatility for less inflation volatility,
and vice versa.
Instruments of Monetary Policy
15
Operating Targets
(reserves, money market
interest rate, etc)
Indicator
variables
Intermediate
Targets
(M2, ER, LT interest
rates, Inflation forecast,
etc)
Policy Objectives
(low and stable inflation)
Monetary
Policy
Framework
Policy Instruments
(OMO, discount rate, etc)
Domestic
shocks
External
shocks
Inflation
Targeting
Policy
Decision
Monetary Policy Framework
Need to answer three questions when designing a
monetary policy framework:
• Which policy instruments to use?
Direct instruments vs. indirect instruments?
• What is the operating target variable?
Targeting prices (interest rates) or quantities (money supply,
credit)?
• What is the monetary policy transmission
mechanism?
How does policy actions on operating target transmit to
intermediate target and then policy objectives? How accurate
and how fast is the transmission?
Choices between policy instruments, intermediate
targets, and final objectives must be compatible.
Policy Instruments
• When implementing monetary policy, central
banks can either act directly, using its regulatory
power, or indirectly, using its influence on
money market conditions.
Direct instruments operate by setting or limiting
either prices or quantities through regulations
Focus on the balance sheets of commercial banks;
Indirect instruments act through the market, by
adjusting the underlying demand for, and supply of,
bank reserves;
Initial effects are on the balance sheet of the central bank.
Direct Instruments
• Direct Controls on interest rates
For instance, minimum and maximum interest rates,
preferential rates for certain loan categories, etc;
• Credit ceilings
At aggregate level or on individual banks;
• Directed lending policies
For instance, preferential central bank refinance
facilities to direct credit to priority sectors;
• High reserve and liquid asset requirements
Designed both to absorb liquidity and to provide
government deficit financing.
Direct Instruments
• Effective means to achieve narrowly defined
targets:
For instance, maintaining a particular interest rate at a certain
level, or keeping a bank’s overall credit expansion below a
certain ceiling, or directing credit to or away from specific sectors.
• Most effective or practical approach in countries
with under-developed financial markets;
• However, the macroeconomic effects of the
controls is hard to predict, because of the scope
for evasion and avoidance.
For instance, effective credit ceiling forces banks to build up
excess liquidity, which in turn discourages deposit taking and
causes disintermediation.
Direct Instruments
• Prevent competition and limit the expansion of
more efficient banks;
• Discourage correct pricing of credit risk, thus
preventing financial resources from being
efficiently allocated;
• Discourage the development of money and capital
markets;
• Inconsistent with freedom of international capital
movement and may encourages “capital flight.”
• Create various administrative problems and
encourage the development of unregulated “grey”
market or “shadow banking.”
Indirect Instruments
• Open-market operations
Outright transactions and repo/reverse repo
agreements
• Standing facilities
“Lender of last resort.”
Discount window, lending and deposit facilities, etc.
• Reserve requirements
Less popular in recent years;
Recent tendency toward lower reserve
requirements.
Indirect Instruments
• Indirect instruments are considered more
market friendly and are less distortionary
than direct instruments.
Focus on system-wide liquidity;
Transmit policy signals;
Allow for optimal allocation of financial resources
on the basis of risk and return.
• Most countries have moved or are moving
towards using indirect instruments.
Transitional Considerations
• Degree of financial development. For instance,
How developed are the financial markets?
How competitive are the commercial banks?
How vulnerable is the banking sector?
• Selection of appropriate target variables and
the interpretation of monetary indicators as
guides to policy.
• Difficulties in controlling monetary aggregates
and credit growth during and after the
transition.
• A gradual approach may be preferred, but not
always.
Choice of Operating Target
25
Operating Targets
(reserves, money market
interest rate, etc)
Indicator
variables
Intermediate
Targets
(M2, ER, LT interest
rates, Inflation forecast,
etc)
Policy Objectives
(low and stable inflation)
Monetary
Policy
Framework
Policy Instruments
(OMO, discount rate, etc)
Domestic
shocks
External
shocks
Inflation
Targeting
Policy
Decision
Choice of Operating Target
Instrument Interest Rate
Interest Rate
Mo
Ro
M1 Money
Md
R1
Ro
Mo Money
Interest Rate
Money Target
• Interest Rates (R) vs. Money Stock (M)
Choice of Operating Target
• Interest Rates (R) vs. Money Stock (M)
• Poole’s (1970) conclusion:
Vol. (aggregate demand shock) > Vol. (money
demand shock) Choose M;
Vol. (aggregate demand shock) < Vol. (money
demand shock) Choose R;
• Quantity Theory of Money
Choice of Monetary Policy Instruments
• In recent years, interest rates have been
preferred among advanced economies as the
primary monetary policy instrument.
provides a more transparent signal of
monetary policy stance;
automatic response to money demand
shocks, in the face of financial innovations.
• For instance, the simple Taylor Rule in the .
Monetary Transmission
Mechanism
Monetary Transmission Mechanism
How do monetary policy actions affect the macro-
economy?
• Money-Interest rate channel
• Credit channel
• Asset price channel
• Exchange rate channel
Monetary
Policy
Market rates
Asset prices
Expectations/
Confidence
Exchange rate
Aggregate
Demand
Import
prices
Inflation
A transmission mechanism of monetary policy
Output
Productivity
Exchange Rate Pass-Through
Policy Rate Pass-Through
32
• Traditional monetary transmission channel; The
effect is felt on the demand for credit.
• Marginal cost of credit
Costs of business investment
Cost of housing or durables purchases
Rate of return to savings
• It is the real interest rate that determines savings/
investment decisions.
Real interest rate = Nominal Interest rate - E ()
Money-Interest rate Channel
Interbank
Call Rate
Discount
Rate
3-Month
T-bill Rate
1-Year
T-Bond Rate
5-Year
T-Bond Rate
10-Year
T-Bond Rate
Lending
Rate
Policy Rate
Deposit
Rate
Crucial to the conduct of monetary policy is how the policy rate is transmitted
to market rates at various maturity spectra—interest rate pass-through.
Interest Rate Pass-Through
Pass-through to Inter-bank Money Market Rates
• The effect of a change in the policy rate on
interest rates in the money market, ., major
commercial bank’s borrowing costs.
Generally money-market rates respond pretty
quickly if markets are well developed;
Money market rates may change even before the
policy rate changes (if anticipated);
However, in periods of financial turbulence, the
response may be impaired (., owing to default
risk during the . financial crisis).
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One-Month Libor-OIS Spreads During Financial Crisis of 2007-2009
Percentage points,
annualized
Failure of
Lehman
Brothers; AIG
(Sep. 15-16)
G-7 action,
Lehman CDS
settlement
(Oct. 10)
TAF
established
(Dec. 12)
TSLF
established
(Mar. 11)
Bear Stearns
bailout
(Mar. 17)
Source: Tao Wu, 2011. “The . Money Market and the Term Auction Facility in
Financial Crisis of 2007-2009,” Review of Economics and Statistics, Volume 93.
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Ja
n-
0
6
Ja
n-
0
6
Ja
n-
0
6
Ja
n-
0
6
Ja
n-
0
6
Ja
n-
0
6
Ja
n-
0
6
Ja
n-
0
6
Fe
b-
06
Fe
b-
06
Fe
b-
06
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06
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06
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06
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06
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06
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06
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ar
-
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6
M
ar
-
0
6
M
ar
-
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ar
-
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ar
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ar
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ar
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ar
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ar
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ar
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pr
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A
pr
-
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ay
-
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ay
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ay
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ay
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ay
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ay
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06
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ay
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06
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ay
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06
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ay
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06
M
ay
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06
Ju
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Ju
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0
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0
6
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0
6
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6
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u
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Se
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06
Se
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06
Se
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06
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06
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06
Se
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06
Se
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06
Se
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06
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ct
-
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ct
-
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ct
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ct
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ct
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ct
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ct
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ct
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ec
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ec
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ec
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ec
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ec
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ec
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Ja
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Ja
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Ja
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Ja
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Ja
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Ja
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Fe
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07
Fe
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ar
-
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M
ar
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M
ar
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M
ar
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M
ar
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pr
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ay
-
07
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ay
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07
M
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ay
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Se
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07
Se
p-
07
Se
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07
Se
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07
Se
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07
Se
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07
Se
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07
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9
Three-Month Libor, Term Fed Funds, and CD-OIS Spreads
3-month Libor-OIS spread
3-month term fed funds-OIS spread
3-month CD-OIS spread
Percentage points, annualized
Failure of
Lehman
Brothers; AIG
(Sep. 15-16)
G-7 action,
Lehman CDS
settlement
(Oct. 10)
TAF established
(Dec. 12)
TSLF
established
(Mar. 11)
Bear Stearns
bailout
(Mar. 17)
Source: Tao Wu, 2011. “The . Money Market and the Term Auction Facility in
Financial Crisis of 2007-2009,” Review of Economics and Statistics, Volume 93.
• Long-term interest rates are the expected
future short-term rates plus term premiums:
• Impact on longer-term interest rates can go
either way, because long-term interest rates
depend on current and expected future short-
term interest rates, and term premiums.
Pass-through to Long-term Interest Rates
The Bond Yield “Conundrum”
The Bond Yield “Conundrum”
Long-term interest rates have trended lower in recent
months even as the Federal Reserve has raised the
level of the target federal funds rate by 150 basis
points. This development contrasts with most
experience, which suggests that, other things being
equal, increasing short-term interest rates are
normally accompanied by a rise in longer-term
yields… For the moment, the broadly unanticipated
behavior of world bond markets remains a
conundrum.
—Testimony of Fed Chairman Alan Greenspan
to the . Senate, February 16, 2005
• Long-term interest rates are the expected
future short-term rates plus term premiums:
• Thus in principle, central banks can adjust
market’s expectations of inflation and future
policy rate, or term premiums (liquidity and
risk premiums) to affect long-term interest
rates.
• Recent examples include the . Federal
Reserve’s monetary policy exercises during
and after the most recent financial crisis.
Pass-through to Long-term Interest Rates
41
• Credit view examines the effect of monetary policy
on the supply of credit instead.
• It stresses on the implications of asymmetric
information between borrowers and lenders.
External finance premium is the difference between the
cost of funds raised externally and the opportunity cost
of internal funds.
Monetary policy affects not only the general level of
interest rates but also the size of the external finance
premium.
Credit Channel
42
• Two mechanisms to explain the linkage between
monetary policy and external finance premium.
Policy tightening tends to reduce the net worth of
businesses and individuals, making it harder for them to
qualify for loans at any interest rate, thus reducing
spending and price pressures — balance sheet channel
Policy rate hikes also make banks less profitable in
general and thus less willing to lend — bank lending
channel
Credit Channel
43
• Factors raising the importance of the credit
channel:
High dependence upon bank credit
Low development of domestic capital markets
Inadequate legal protection of creditors
• Empirically, the relative availability of bank
credit may be a useful predictor of future
investment and output.
Credit Channel
Asset Price Channel
• Monetary policy affects asset prices (equities
and real estates);
• Changes in asset prices, in turn, affect
consumption and investment.
Effects on Household Consumption
• Equity and real estate prices affect:
Household wealth and hence consumption
(wealth effect)
Household’s borrowing capacity to finance
current consumption.
• Equity prices affect corporate investment via Tobin’s q:
Investment increases when the market value of a firm relative to its
replacement cost rises.
• Corporate balance sheet effect: The net worth of a firm
affects the external finance premium and the cost of capital
Changes in collateral values affect eligibility for bank loans and thus
investment.
• Bank balance sheet effect: Banks’ capital position and
lending capacity declines when the net worth is adversely
affect by declines in asset price credit crunch.
Effects on Business Investment
47
Asset prices
Expectations/
Confidence
External
Financing Cost
Balance
Sheets:
Investors
and Banks
Tobin’s q
Asset Price Channel: Financial Accelerator
Investment
Output
A spiral between asset prices
and aggregate demand
The Exchange Rate Channel
• When the exchange rate is floating, monetary
policy could have systematic effects on the
exchange rate.
• Tighter monetary policy leads to exchange
rate appreciation, which reduces price
pressures:
Aggregate demand: appreciation reduces net
exports
Aggregate supply (cost): appreciation reduces
domestic currency value of imports
Pass-through from Exchange Rate to Inflation
• Pass-through from exchange rates to import prices
exhibits cross-sectional differences
In emerging markets usually faster than in advanced countries
It depends on price setting behavior or concern about market
share
Pass-through effects could be endogenous
• For the ., long-run pass-through only 24-29%; for
Germany 40-100%; for Japan 80-100%.
• Choi and Cook (2008, IMFWP/08/213) estimate pass-
through effects using a new Keynesian model.
The estimated pass-through effect is filtering very slowly. For
the ., only 7% of the importers will change their prices in
response in each quarter after the shock.
50
• It takes time for changes in monetary policy
instrument to have maximum impact on
macro economy.
Change in
instrument
Market rates
Asset prices
Expectations/
confidence
Exchange rate
Domestic
inflationary
pressure Inflation
18-24 months12-18 monthsChanges can be anticipated
Lags for the Monetary Policy to Take Effect
Lags for the Monetary Policy to Take Effect
• Therefore, monetary policy needs to be pre-emptive.
• This requires clear understanding of macroeconomic
structure, correct identification of the underlying
shocks, accurate data collection, and reliable
forecasting.
• Challenges faced by policy-makers in real time are
daunting
model uncertainty, parameter uncertainty, data uncertainty, etc.
• The conduct of monetary policy will remain both a
science and an art.
The . Federal Reserve’s Unconventional
Monetary Policy
. Monetary Policy During the Crisis
• Overview of financial crisis and recession
• Federal Reserve’s Policy Response
Extraordinary provision of liquidity
Cuts in short-term interest rates
Communication of future policy guidance
Purchases of long-term debt securities
• Excess reserves and inflation expectations
• Exit strategy of the unconventional monetary
policy
Credit Boom and Housing Bubble: 2000-2005
• Flood of international capital, low interest
rates, and ample liquidity induced a credit
boom with especially rapid growth in
residential borrowing.
• Investors underestimated underlying credit
risks. They were misled by unreliable credit
ratings and complicated structured finance
products.
• Inadequate financial supervision and
regulation.
Credit Boom and Housing Bubble: 2000-2005
• Credit boom was reinforced by rising home
prices, low default rates, and a loosening of
underwriting standards—especially on loans to
be securitized.
• Credit boom and housing bubble: 2000-2005
Credit Boom Inflates with Housing Bubble
House prices increase
(Housing bubble)
Home equity
rises
Delinquencies
fall
Credit terms
loosen
Housing
demand rises
(Credit
boom)
Financial Crisis and Recession
• . housing bubble started to deflate in 2005
-2006.
• Rising mortgage delinquencies in early 2007
stunned investors. Mortgage-backed
securities (MBS) lost value, as did other asset
-backed securities (ABS).
• Uncertainty about the size and location of
these financial losses in the financial system
led to withdrawal of liquidity and a clamp
down on credit.
Financial Crisis and Recession
• Financial institutions/markets came under
tremendous stress.
• . economy entered recession in December
2007.
Adverse Feedback Cycle in Reverse
House prices decreases
(Housing bust)
Home equity
falls
Delinquencies
rise
Credit terms
tighten
Housing
demand falls
(Credit
crunch)
Ja
n-
0
6
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0
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0
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0
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0
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06
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ar
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A
u
g-
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u
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Se
p-
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Se
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Se
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Se
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Se
p-
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Se
p-
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Se
p-
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Se
p-
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Se
p-
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Se
p-
06
O
ct
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6
O
ct
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O
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ct
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N
o
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D
ec
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D
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Ja
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Ja
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Ja
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Ja
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Ja
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Ja
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Ja
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Ja
n-
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Fe
b-
07
Fe
b-
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Fe
b-
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Fe
b-
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Fe
b-
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Fe
b-
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Fe
b-
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Fe
b-
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Fe
b-
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M
ar
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7
M
ar
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M
ar
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M
ar
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M
ar
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M
ar
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M
ar
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M
ar
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M
ar
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M
ar
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M
ar
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A
pr
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A
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A
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A
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M
ay
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M
ay
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M
ay
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M
ay
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M
ay
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M
ay
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M
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M
ay
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M
ay
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M
ay
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
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Ju
l-
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Ju
l-
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Ju
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Ju
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Ju
l-
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Ju
l-
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A
u
g-
0
7
A
u
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7
A
u
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A
u
g-
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A
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A
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A
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A
u
g-
0
7
A
u
g-
0
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A
u
g-
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A
u
g-
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7
Se
p-
07
Se
p-
07
Se
p-
07
Se
p-
07
Se
p-
07
Se
p-
07
Se
p-
07
Se
p-
07
Se
p-
07
Se
p-
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O
ct
-
0
7
O
ct
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O
ct
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O
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O
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O
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O
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O
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O
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N
o
v-
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N
o
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N
o
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N
o
v-
0
7
N
o
v-
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7
N
o
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0
7
N
o
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7
N
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N
o
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N
o
v-
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D
ec
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0
7
D
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0
7
D
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0
7
D
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0
7
D
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0
7
D
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0
7
D
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0
7
D
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0
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D
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0
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D
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0
7
Ja
n-
0
8
Ja
n-
0
8
Ja
n-
0
8
Ja
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0
8
Ja
n-
0
8
Ja
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0
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Ja
n-
0
8
Ja
n-
0
8
Ja
n-
0
8
Ja
n-
0
8
Ja
n-
0
8
Fe
b-
08
Fe
b-
08
Fe
b-
08
Fe
b-
08
Fe
b-
08
Fe
b-
08
Fe
b-
08
Fe
b-
08
Fe
b-
08
M
ar
-
0
8
M
ar
-
0
8
M
ar
-
0
8
M
ar
-
0
8
M
ar
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0
8
M
ar
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0
8
M
ar
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8
M
ar
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0
8
M
ar
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0
8
M
ar
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8
M
ar
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0
8
A
pr
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0
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A
pr
-
0
8
A
pr
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0
8
A
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0
8
A
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A
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0
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A
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0
8
A
pr
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0
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A
pr
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A
pr
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0
8
M
ay
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08
M
ay
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08
M
ay
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08
M
ay
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08
M
ay
-
08
M
ay
-
08
M
ay
-
08
M
ay
-
08
M
ay
-
08
M
ay
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08
Ju
n-
0
8
Ju
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8
Ju
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Ju
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Ju
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Ju
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Ju
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8
Ju
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8
Ju
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8
Ju
n-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
Ju
l-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
A
u
g-
0
8
Se
p-
08
Se
p-
08
Se
p-
08
Se
p-
08
Se
p-
08
Se
p-
08
Se
p-
08
Se
p-
08
Se
p-
08
Se
p-
08
O
ct
-
0
8
O
ct
-
0
8
O
ct
-
0
8
O
ct
-
0
8
O
ct
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0
8
O
ct
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0
8
O
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0
8
O
ct
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0
8
O
ct
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0
8
O
ct
-
0
8
N
o
v-
0
8
N
o
v-
0
8
N
o
v-
0
8
N
o
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0
8
N
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0
8
N
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0
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N
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0
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N
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0
8
N
o
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0
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N
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0
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D
ec
-
0
8
D
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0
8
D
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0
8
D
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0
8
D
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8
D
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D
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0
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0
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D
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8
Ja
n-
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9
Ja
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Ja
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Ja
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Ja
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Ja
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Ja
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9
Chart 1: Three-Month Libor, Term Fed Funds, and CD-OIS Spreads
3-month Libor-OIS spread
3-month term fed funds-OIS spread
3-month CD-OIS spread
Percentage points, annualized
Failure of
Lehman
Brothers; AIG
(Sep. 15-16)
G-7 action,
Lehman CDS
settlement
(Oct. 10)
TAF established
(Dec. 12)
TSLF
established
(Mar. 11)
Bear Stearns
bailout
(Mar. 17)
0 1 2 3 4 5 6 7 8 9 10 11 12 13
10
8
6
4
2
0
-2
-4
-6
-8
-10
Real Gross Domestic Product (GDP)
Quarterly percent change
0 1 2 3 4 5 6 7 8 9 10 11 12 13
10
9
8
7
6
5
4
3
2
1
0
Unemployment Rate in the .
Percent
The Fed’s Policy Responses
• Extraordinary provision of liquidity
“Lender as last resort”
Liquidity injection facilities and the
“stigma problem”
• Cuts in short-term interest rates
• Forward guidance: Communications over
future monetary policy stance
• Purchases of long-term debt securities
Extraordinary Supply of Liquidity
Short-term Rate Cut to Almost Zero
Then It was Constrained by A “Zero Lower Bound”
Policy Options After Short Rates Hit the
Zero Lower Bound (ZLB)
Unconventional Monetary Policy (UMP)
measures:
• Forward guidance: Communications over
future monetary policy stance
• Quantitative easing: Purchases of long-term
debt securities
• Long-term interest rates are the expected
future short-term rates plus term premiums:
•Therefore in principle, central banks can adjust
the current policy rate, or market’s
expectations of future policy rate, or term
premiums (liquidity and risk premiums) to
affect long-term interest rates.
Pass-through to Long-term Interest Rates
•When the policy rate hits the zero lower bound (ZLB), a
central bank may still be able to affect long-term interest
rates and aggregate demand:
Through changing market’s expectations of future
policy rate.
Through changing term premiums.
Pass-through to Long-term Interest Rates
The Federal Reserve’s Forward Guidance
• Communicate a long-term anchor for inflation
“Most [FOMC] participants judged that a longer-run
PCE inflation rate of 2 percent would be consistent with
the dual mandate [of maximum employment and price
stability].” (2/18/09)
• Conditionally promise future low interest rates:
“The Committee . . . anticipates that economic
conditions are likely to warrant exceptionally low levels
of the federal funds rate for an extended
period.”(3/18/09)
FOMC Statement on August 9, 2011:
“To promote the ongoing economic recovery and to help
ensure that inflation, over time, is at levels consistent
with its mandate, the Committee decided today to keep
the target range for the federal funds rate at 0 to 1/4
percent. The Committee currently anticipates that
economic conditions--including low rates of resource
utilization and a subdued outlook for inflation over the
medium run--are likely to warrant exceptionally low
levels for the federal funds rate at least through
mid-2013.”
The Federal Reserve’s Forward Guidance
FOMC Statement on January 25, 2012:
“To support a stronger economic recovery and to help
ensure that inflation, over time, is at levels consistent
with the dual mandate, the Committee expects to
maintain a highly accommodative stance for monetary
policy. In particular, the Committee decided today to
keep the target range for the federal funds rate at 0 to
1/4 percent and currently anticipates that economic
conditions--including low rates of resource utilization
and a subdued outlook for inflation over the medium
run--are likely to warrant exceptionally low levels
for the federal funds rate at least through late
2014.”
The Federal Reserve’s Forward Guidance
FOMC Statement on September 13, 2012:
“To support continued progress toward maximum
employment and price stability, the Committee expects
that a highly accommodative stance of monetary policy
will remain appropriate for a considerable time after the
economic recovery strengthens. In particular, the
Committee also decided today to keep the target range
for the federal funds rate at 0 to 1/4 percent and
currently anticipates that exceptionally low levels for
the federal funds rate are likely to be warranted at
least through mid-2015.”
The Federal Reserve’s Forward Guidance
FOMC Statement on December 12, 2012:
“In particular, the Committee decided to keep the target
range for the federal funds rate at 0 to 1/4 percent and
currently anticipates that this exceptionally low range
for the federal funds rate will be appropriate at least as
long as the unemployment rate remains above 6-
1/2 percent, inflation between one and two years
ahead is projected to be no more than a half
percentage point above the Committee’s 2 percent
longer-run goal, and longer-term inflation
expectations continue to be well anchored. ”
The Federal Reserve’s Forward Guidance
The Federal Reserve’s Forward Guidance
• Statement helps inform financial markets:
It lowers expectations of future short-term rates and
hence lowers long-term rates.
Anticipation of future low rates is explicitly
dependent on future economic data.
FOMC announcement on November 25, 2008 on
the first purchase “QE1”:
“The Federal Reserve announced on Tuesday that it will
initiate a program to purchase the direct obligations of
housing-related government-sponsored enterprises
(GSEs) … Purchases of up to $100 billion in GSE
direct obligations under the program ... Purchases
of up to $500 billion in MBS ... Purchases of both
direct obligations and MBS are expected to take place
over several quarters.”
Large Scale Asset Purchases (LSAP)
FOMC statement on March 18, 2009 on
expanding the “QE1”:
“To provide greater support to mortgage lending and
housing markets, the Committee decided today to
increase the size of the Federal Reserve’s balance
sheet further by purchasing up to an additional $750
billion of agency mortgage-backed securities,
bringing its total purchases of these securities to up to
$ trillion this year, and to increase its purchases
of agency debt this year by up to $100 billion to a
total of up to $200 billion. Moreover, to help improve
conditions in private credit markets, the Committee
decided to purchase up to $300 billion of longer-
term Treasury securities over the next six months. .”
Large Scale Asset Purchases (LSAP)
FOMC statement on November 3, 2010 on
expanding the “QE2”:
“The Committee will maintain its existing policy of
reinvesting principal payments from its securities
holdings. In addition, the Committee intends to
purchase a further $600 billion of longer-term
Treasury securities by the end of the second quarter
of 2011, a pace of about $75 billion per month. The
Committee will regularly review the pace of its
securities purchases and the overall size of the asset-
purchase program in light of incoming information and
will adjust the program as needed to best foster
maximum employment and price stability.”
Large Scale Asset Purchases (LSAP)
FOMC statement on September 21, 2011 on
“Operation Twist”:
“The Committee intends to purchase, by the end of June
2012, $400 billion of Treasury securities with
remaining maturities of 6 years to 30 years and to sell
an equal amount of Treasury securities with remaining
maturities of 3 years or less. This program should put
downward pressure on longer-term interest rates and
help make broader financial conditions more
accommodative.”
Large Scale Asset Purchases (LSAP)
FOMC Statement on September 13, 2012 on
“QE3”:
“To support …, the Committee agreed today to increase
policy accommodation by purchasing additional agency
mortgage-backed securities at a pace of $40 billion per
month. The Committee also will …, and it is
maintaining its existing policy of reinvesting principal
payments from its holdings of agency debt and agency
mortgage-backed securities in agency mortgage-
backed securities. These actions, which together will
increase the Committee’s holdings of longer-term
securities by about $85 billion each month through the
end of the year, should put downward pressure on
longer-term interest rates, support mortgage
markets, and help to make broader financial conditions
more accommodative.”
Large Scale Asset Purchases (LSAP)
QE1’s Effects on Treasury Bond Yields
1 2 3 4 5 6 7 8 9 10
Bond Maturity (in years)
One Day Before
Announcement
(March 17, 2009)
Announcement Day
(March 18, 2009)
Percent
Treasury bond yields fell after
March 18, 2009 FOMC
announcement of $ trillion
purchase of MBS and $300 billion
purchases of Treasury securities.
One Day After
Announcement
(March 19, 2009)
One Week After
Announcement
(September 28, 2011)
QE2’s Effects on Treasury Bond Yields
1 2 3 4 5 6 7 8 9 10
Bond Maturity (in months)
One Day Before
Announcement
(November 2, 2010)
Announcement Day
(November 3, 2010)
One Day After
Announcement
(November 4, 2010)
Percent
Effects of the announcement on
November 2, 2010 of $600 billion
purchases were rather limited.
One Week After
Announcement
(November 10, 2010)
Operation Twist’s Effects on Treasury Bond Yields
1 2 3 4 5 6 7 8 9 10
Bond Maturity (in months)
One Day Before
Announcement
(September 20, 2011)
Announcement Day
(September 21, 2011)
One Day After
Announcement
(September 22, 2011)
Percent
Effects of the announcement of the
"Operation Twist" program on
September 21, 2011, under which the
Fed was going to sell $400 billion in
short-term Treasuries in exchange for
the same amount of long-term bonds,
again, were very limited.
One Week After
Announcement
(September 28, 2011)
QE3’s Effects on Treasury Bond Yields
1 2 3 4 5 6 7 8 9 10
Bond Maturity (in months)
One Day Before
Announcement
(September 12, 2012)
Announcement Day
(September 13, 2012)
One Day After
Announcement
(September 14, 2012)
Percent
Effects of the announcement of QE3
on September 13, 2012, under which
the Fed planned to purchase the MBS
at a pace of $40 billion each month,
One Week After
Announcement
(September 20, 2012)
Decomposition of Changes in Ten-Year Term Premium: Sep. 2008 – May
2013
0. Changes in 10-year Treasury yield (bps)
Of which
1. Changes in 10-year Term Premium
Of which
2. Changes in macroeconomic fundamentals
3. Changes in macroeconomic uncertainties
4. Changes in financial market volatilities and
near-future policy-rate uncertainty
5. Change in the PDV of excess SOMA balance
Of which
“QE I” phase
“QE II” phase
“Operation Twist” phase
“QE III” phase
Periods w/o active purchases
6. Residuals
Transmission Mechanism of the UMP in the .
Forward
Guidance
LSAP
Expectation
of Future
Short Rate
Term
Premiums
Long-
Term
Interest
Rates
Aggregate
Demand
Private
Borrowing
Costs
Confidence
Assessing Unconventional Monetary Policy
• Benefits of balance sheet policies:
Improve financial conditions and credit supply
Shorten economic downturn
• Potential risks of balance sheet policies:
Too much money may lead to higher inflation
Problems in unwinding programs (need to specify
an explicit “exit strategy”!)
Policy Stimulus NOT Inflating Economy
The Fed is NOT in a situation of “Too much money
chasing too few goods producing inflation.”
• More bank reserves have not produced too
much money. Banks are hoarding reserves.
Lending is falling. Broad money supply is little
changed.
• Also, current downturn does not have too few
goods, but excess capacity and unemployment.
• Policy stimulus not overinflating economy … yet.
Policy Stimulus NOT Inflating Economy
3 4 5 6 7 8 9 10 11 12 13
0
50
100
150
200
250
300
350
400
450
500
Monetary Base
(bank reserves + currency)
M2
Commercial and
Industrial Loans
Outstanding Non-financial
Commercial Paper
Index, SA, Money Base, Money Supply, and Credit
Jan-00
0
100
200
300
400
500
Index, SA,
Jan. 07 = 100
Monetary Base
(bank reserves + currency)
Money Supply
(M2)
Money Supply
(M1)
Money Growth in the .: 2007-2013
Long-run Inflation Expectation Well Anchored
7 8 9 10 11
0
1
2
3
4
0
1
2
3
4
5
Money Base
10-year ahead CPI
Trillions of Dollars Percent
12-month Core
PCEPI Inflation
Policy Options After Hitting the ZLB
• Guide market’s expectations on future short-
term interest rate through “Forward Guidance”
communications;
• Propose price-level or higher inflation target;
Or other more structural “Forward Guidance”
approaches.
• Asset purchases to lower long-term interest
rates.
Fed’s Current “Exit Strategy”
• Taper pace of purchases: cease reinvestment
of principal payments on securities holdings.
• Modify forward guidance and implement
temporary reserve-draining operations.
• Increase policy rates. Make adjustments to the
IOER to help bring the effective fed funds rate
to its target.
• Continue to allow securities to run-off passively
until reserves reach manageable level.
“No sale” exit strategy is desired outcome,
but consider asset sales, as needed
Summary
• Financial crisis called for the unconventional policy
actions by the Federal Reserve.
• Fed’s extraordinary provision of liquidity to
financial system in 2007-2009 had prevented a
further collapse and had effectively ended the
financial crisis.
• Current loose monetary policy is geared to
stimulate the economy, after short-term interest
rate hitting the zero bound.
• Need to clearly specify an exit strategy to convince
the market that when the economy recovers,
monetary policy can return to normal quickly.
