The Atlanta Fed's macroblog provides commentary on economic topics including monetary policy, macroeconomic developments, financial issues and Southeast regional trends.

Authors for macroblog are Dave Altig and other Atlanta Fed economists.

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November 25, 2008

How should we think about the monetary transmission mechanism?

That’s always a relevant question, but it takes on some added importance in times like these when the federal funds rate—the standard policy target for the Federal Open Market Committee—approaches its lower bound of zero. The recent introduction of a policy to pay banks interest on the reserves they hold on account with the Federal Reserve—which presumably (though puzzlingly not yet operationally) puts a floor on the federal funds rate independent of how much liquidity the central banks pumps into the economy— raises the question afresh.

A week or so back, Glenn Rudebusch, associate research director at the San Francisco Fed, offered his view on this topic:

“Although the funds rate target cannot be lowered much further—and certainly not below zero—it is not the case that the Federal Reserve is necessarily 'on hold.' Indeed, the Fed has already started to employ alternative means for conducting monetary policy in order to stimulate the economy.

“There are three key strategies for a central bank to stimulate the economy when short-term interest rates are fixed at zero or near zero. The first is to attempt to lower longer-term interest rates and boost other asset prices by managing market expectations of future policy actions. Specifically, a credible public commitment to keep the funds rates low for a sustained period of time can push down expectations of future short-term interest rates and lower long-term interest rates and boost other asset prices. Such a public commitment could be unconditional, such as 'maintained for a considerable period' or it could be conditional, such as 'until financial conditions stabilize.' The FOMC made such a commitment in 2003 after the funds rate was lowered to 1 percent and the economy remained weak. With the funds rate currently quite low, the Fed may revisit this strategy. If so, there would appear to be considerable scope for such a strategy to work, as the 10-year U.S. Treasury bond yield remains around 4 percent. When the Bank of Japan promised in 2001 to keep its policy rate near zero as long as consumer prices fell, it was able to help push the rate on 10-year government securities down below 1 percent.”

Rudebusch goes on to discuss the other two strategies—worth reading and examining here at a later time—but I think it is interesting to contrast this first statement of strategy with the following, from Tobias Adrian and Hyun Song Shin (of the Federal Reserve Bank of New York and Princeton University, respectively):

“We find that the level of the Fed funds target is key. The Fed funds target determines other relevant short term interest rates, such as repo rates and interbank lending rates through arbitrage in the money market. As such, we may expect the Fed funds rate to be pivotal in setting short-term interest rates more generally. We find that low short-term rates are conducive to expanding balance sheets. In addition, a steeper yield curve, larger credit spreads, and lower measures of financial market volatility are conducive to expanding balance sheets. In particular, an inverted yield curve is a harbinger of a slowdown in balance sheet growth, shedding light on the empirical feature that an inverted yield curve forecasts recessions.”

That empirical feature is in fact documented by Rudebusch and John Williams. Adrian and Shin continue:

“These findings reflect the economics of financial intermediation, since the business of banking is to borrow short and lend long…

“… our results suggest that the target rate itself matters for the real economy through its role in the supply of credit and funding conditions in the capital market. As such, the target rate may have a role in the transmission of monetary policy in its own right, independent of changes in long rates.”

Interestingly, the “considerable period of time” episode referred to in the Rudebusch excerpt above coincided with an increase in long-term interest rates and a steepening of the yield curve:

Interest Rates: 2002-2004

So, if stimulative monetary policy is what we are after, should we be looking for lower long-term rates or higher long-term rates? Discuss.

By David Altig, senior vice president and director of research at the Atlanta Fed

Because of the Thanksgiving holiday, today’s posting will be the only macroblog posting for this week.

November 25, 2008 in Federal Reserve and Monetary Policy, Interest Rates | Permalink


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I think there is much validity to the argument that a steepening yield curve is a key ingredient to jumpstarting economic activity. Ideally, 300 basis points or more between the 30-yr bond and 3-mo T-bill is enough to encourage lenders to borrow short and lend long in a risky environment. I think the lack of a clear policy commitment is having a negative impact in this panic-driven environment. I am looking for the Fed to lay out in clear terms how they intend to loosen policy going forward given the real limitations of impending ZIRP.

Once a clear monetary policy is established, participants will be able to take actions without fearing unanticipated Fed (re)actions to market conditions could hurt them. The more transparency and clear direction, the better if we expect lenders to take risk.

best wishes,

Posted by: Bob Brinker | November 25, 2008 at 07:23 PM

If we are trying to increase bank capital, higher long term interest rates would allow banks to borrow short and lend long with a larger net interest margin.

If we are trying to stimulate investment, lower long term interest rates would encourage companies to borrow to increase productive capacity.

Given the dangers of deflation and the fact that we are not using the productive capacity we have, we should adopt the first policy. Until banks have the confidence to lend to companies and individuals with good credit ratings, the level of short term interest rates will have no effect on economic performance.

Posted by: Rajesh Raut | November 25, 2008 at 09:45 PM

First, Happy Thanksgiving and keep blogging.

I think at this time, it is critical that the Fed keep rates low. Once the economy shows signs of life, they can begin ratcheting them up. The last chart is interesting. If you think about the explosion of leverage in the market, it may account for the steepening of the curve. Because hedge funds, and investment funds could get better returns in the market, they were voracious borrowers to get more cash to get more return.

The amount of subprime/alt-a activity also increased significantly from 2001-2007, and I believe the velocity of that increase was steeper from 04-07 (would have to check) This could also account for the steepening.

As an aside, there was a trade in the 30 year bond option last week. An out of the money strike traded for half a tick-effectively pricing the 30 year at 0%. That should give anyone a shudder.

Posted by: Jeff | November 25, 2008 at 10:58 PM

My concern with this post is the following:

We know how the Fed used to run monetary policy and we know how short-term interest rates used to work. But I don't think the past should be treated as a good indicator of the future in the current environment. I think the Fed should be preparing for the possibility that changes in the target rate have a minimal effect on any interest rates of more than one year duration.

Of course, by all means try Rudebusch's public commitment method -- just make sure you have a plan B in case it doesn't work.

Posted by: Anonymous | November 26, 2008 at 12:52 PM

"The 10-year U.S. Treasury bond yield remains around 4 percent."

Bloomberg quotes 2.98, close to historical lows.

Posted by: rogier kamerling | November 26, 2008 at 01:44 PM

It's supply and demand, innit? Cause and consequence?

An increased SUPPLY of long loans (from the Fed) will lower long rates, increase investment, and help CAUSE a recovery.

When recovery starts, the increased investment, and increased DEMAND for long loans (from firms and households), will raise long rates, and will be a CONSEQUENCE of the recovery.

Posted by: Nick Rowe | November 27, 2008 at 03:53 PM


the fed cannot engineer a recovery by itself. it can pursue an easy money policy, but until actual business gets going (not by a boost from the government), GDP will continue to wane.

Posted by: Jeff | December 01, 2008 at 09:31 PM

We want LOWER longer term interest rates. I'm perplexed that you should ask.

Preventable foreclosures are a key issue we are addressing. To the extent they are tied to 10-year Treasury rates, lower rates obviously help keep people in their homes.

In a time of massive deflation that will be caused by extraordinary debt overhangs and a worldwide COLLAPSE in consumer demand, to argue whether higher longer term rates would exacerbate or ameliorate the situation poses serious questions about the fundamental grasp of the problem.

Posted by: Matt Dubuque | December 02, 2008 at 03:39 PM

As previously stated two months ago in this forum, the Fed needs to IMMEDIATELY buy long term securities and SELL short term Treasuries, a reprise of Operation Twist from the 1960s.

Doing so will lengthen the time horizon of actors and yet support the dollar at the same time.

Posted by: Matt Dubuque | December 02, 2008 at 03:41 PM

Lower long-term interest rates. From a spending perspective, the last thing we need now, with inflation falling, is long-term interest rates rising. In other words, we want the real interest rate to fall not rise.

Isn't this the idea behind the Taylor principle? As inflation falls, lower real interest rates will help stimulate spending, which, in turn, enables the economy's readjustment back towards potential?

In fact, isn't the likelihood that the Taylor Principle may not be operable (by reaching the zero interest floor) a major reason why this recession is different from all of the other post WWII recession?

Posted by: SMG | December 04, 2008 at 08:51 PM

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