The three faces of postcrisis monetary policy

The latest edition of the San Francisco Fed's Economic Letter (written by Michael Bauer)has a nice review of the different channels through which the Fed's Large Scale Asset Purchase (LSAP) programs—QE, or quantitative easing more popularly—are thought to work:

"Central bank LSAPs potentially may affect interest rates through at least three channels. Notably, all three channels can broadly affect longer-term interest rates, extending beyond those securities that the central bank announces it will purchase:

• A portfolio balance channel, because the supply of long-maturity bonds available to private investors is reduced. The reduced supply of longer-term securities targeted by the Fed lowers the amount of interest rate risk in investor portfolios. That in turn decreases the risk premium that they require to hold both the targeted securities and other assets of similar duration. Longer-term interest rates are lowered across the board as a result. Gagnon et al (2011) emphasize this channel for QE1.
• A signaling channel, which arises when the Fed's announcements are interpreted as signals of its intent to hold down short-term interest rates further into the future. Bauer and Rudebusch (2011) argue that this channel played an important role for QE1.
• A market functioning channel, because QE1 provided relief when conditions in financial markets were dire, liquidity very low, and panic widespread. The Fed's intervention calmed investor fears. Thus, the intervention substantially supported a range of asset prices, including MBS and corporate bonds, lowering their yields."

The article references include links to the Gagnon et al. paper and the Bauer and Rudebusch paper, but none to any studies addressing the "market functioning channel." So I'll provide one: "Did the Federal Reserve's MBS Purchase Program Lower Mortgage Rates?" by Diana Hancock and Wayne Passmore, both senior staff members for the Federal Reserve of Board of Governors. According to Hancock and Passmore, the market functioning channel is key to appreciating the impact of QE1:

"We use empirical pricing models for MBS yields in the secondary mortgage market and for mortgage rates paid by homeowners in the primary mortgage market to measure how distorted mortgage markets were prior to the Federal Reserve's intervention, and the course of market risk premiums during the restoration to normal market functioning...

"We argue that this return to normal pricing occurred because the Federal Reserve's announcement signaled a strong and credible government backing for mortgage markets in particular and for the financial system more generally...

"More specifically, we estimate that the Federal Reserve's MBS purchase program over the course of 16 months reestablished normal market pricing in the MBS market and resulted in lower mortgage rates of roughly 100 to 150 basis points for purchasing houses. Most of the decline in mortgage rates occurred between the announcement of the program, on November 25, 2008, and the implementation of the program in the first quarter of 2009. After this point, both mortgage rates and risk premiums remained relatively stable until the end of the Federal Reserve MBS purchase program."

Hancock and Passmore note that the portfolio balance channel may have played a role after the completion of the QE1 purchases once market functioning had normalized, but the biggest bang was that renormalization itself.

Bauer's observations align with Hancock and Passmore's conclusions:

"QE1 had very pronounced effects on interest rates. The key announcements led to decreases of close to one percentage point. The announcements not only lowered yields on targeted Treasury securities and MBS, but also on corporate bonds...

"The two other programs, QE2 and MEP [maturity extension program], also affected yields of securities that were not targeted for Fed purchases... Generally though, QE2 and MEP affected interest rates much less than QE1 did. One reason is that bond market functioning had largely returned to normal. In addition, expectations of future short-term interest rates were already very low when these programs were announced, leaving little room for further signaling effects. Finally, QE2 and MEP were smaller than QE1."

Earlier this week, in a speech delivered in Tokyo at the Institute of Regulation and Risk, Federal Reserve Bank of Atlanta President Dennis Lockhart provided his view on this evidence:

"In my view, these [the QE1] purchase programs played an important role in the transition away from the emergency lending facilities created earlier in the crisis. The emergency credit facilities worked well to stem the downward spiral of the immediate post-Lehman period. Financial markets began the process of repair during the first half of 2009 but were still suffering from relatively serious liquidity pressures. The QE1 operation sustained the liquidity support that had been previously provided by lending through the emergency facilities.

"Because asset purchases largely replaced emergency loans made during the crisis, the net increase in the Fed's balance sheet was relatively modest. In this sense, the quantitative easing label is misleading. The intent and effect of the policy was not to inject a new and sizable quantity of reserves into the economy. Rather, the effect was to sustain liquidity in still struggling and fragile financial markets, particularly those related to residential real estate. For that reason, I prefer the term ‘credit easing' to describe this policy action."

However, the smaller impact of QE2 leads Lockhart to a different conclusion regarding the largest contribution of that program:

"I view QE2 differently. The FOMC [Federal Open Market Committee] formally announced QE2 in November 2010, with its decision to purchase $600 billion in longer-term Treasury securities. However, the policy was signaled in an important speech from Federal Reserve Chairman Ben Bernanke in August of that year. The circumstances at the time were dominated by a falling trend in measured inflation, weakening inflation expectations, and rising probabilities of outright deflation. Each of these developments was effectively reversed as the expectations for QE2 took root, expectations that were ultimately validated by FOMC action.

"Unlike QE1, QE2 did materially expand the size of the Federal Reserve's balance sheet. In my view, this distinction is important. The intent and effect of the two rounds of asset purchases were different. QE1 served to maintain liquidity at a time when financial markets were exceptionally unsettled. In contrast, QE2 was a more traditional monetary action to preserve price stability."

In a sense, this places the effects of QE2 in the signaling channel category, albeit with an emphasis on inflation expectations rather than interest rates directly.

Bauer's article also covers post-QE2 policy—the maturity extension program (MEP, or "Operation Twist") and the insertion of specific calendar dates (currently at least late 2014) to provide forward guidance on the period of time that the FOMC anticipates that the federal funds rate will remain at exceptionally low levels. Lockhart also describes these policies in terms of the "signaling channel," though in these cases with interest rate effects front and center:

"In terms of intent and effect, I think of the explicit forward guidance and the MEP in similar terms. We have entered a phase of the recovery in which sustained monetary accommodation is warranted in order to preserve and advance what is still modest progress on employment and economic growth. Importantly, this modest progress is occurring in the context of what, for me, is acceptable performance with respect to our price stability mandate. Actions that reinforce the maintenance of policy accommodation are appropriate. It is through that lens that I view the MEP and explicit forward guidance on policy rates."

Lockhart's remarks provide his perspective on three somewhat distinct policy challenges—market dysfunction, disinflationary pressures, and a need to sustain monetary policy accommodation—that motivate his support for the three major policy initiatives of the postcrisis period:

"Let me summarize this brief tour of postcrisis monetary policy. I view the sequence of nontraditional monetary policy actions as tailored responses to the particular needs of the economy and financial system at the time they were implemented. My conclusion is that by and large policy actions have been appropriate to the diagnosis of circumstances at the time. And in my assessment they have worked pretty well."

In this light, President Lockhart delivers his policy punch line:

"I have reframed to some extent the original question of what more can be done around the point that policy actions must be matched to circumstances. The challenge policymakers face is judging appropriateness of a tool for circumstances. As popular as it might be in some quarters to rule out further LSAPs (QE3, as it is known), I do not think this option can be taken off the table. QE3 will work under the right circumstances. But I don't believe such circumstances prevail at this time."

By Dave Altig, executive vice president and research director at the Atlanta Fed

 

In the interest of precision

As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):

"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."

A similar description appeared in the Journal yesterday (again, emphasis added):

"The Fed has just taken a historic step towards increasing its transparency and accountability by saying it will begin to release interest-rate projections several years out at the conclusion of its next policy meeting on Jan. 25. This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."

I added the emphasis in both of those passages because I think the highlighted language isn't quite right. Here is the actual language that appears in the FOMC minutes:

"In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.…

"… participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions."

The minutes are pretty clear about what this information is intended to convey…

"Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions."

…and what it is not intended to convey (here too, emphasis added):

"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"

In fact, the first Journal piece mentioned above does document some of the expressed concerns near the end of the article. For example:

"… some might mistakenly see the forecasts as an ironclad commitment, rather than a projection that could change as economy evolves."

That caveat does speak to concerns of some FOMC participants that the projections would establish a specific policy path. But the issue is about more than maintaining flexibility in the face of changing economic conditions. The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.

This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.

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

 

Fed Treasury purchases: How big is big?

In his July 13 testimony to Congress, Federal Reserve Chairman Ben Bernanke discussed the large-scale asset purchase program to buy $600 billion of longer-term Treasury securities that started in November 2010 and was completed in June 2011. The chairman noted:

"The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program—like more conventional monetary policy—has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy."

Chairman Bernanke went on to observe in a footnote in his prepared remarks from that testimony:

"The Federal Reserve's recently completed securities purchase program has changed the average maturity of Treasury securities held by the public only modestly, suggesting that such an effect likely did not contribute substantially to the reduction in Treasury yields. Rather, the more important channel of effect was the removal of Treasury securities from the market, which reduced Treasury yields generally while inducing private investors to hold alternative assets (the portfolio reallocation effect). The substitution into alternative assets raised their prices and lowered their yields, easing overall financial conditions."

In a similar way, the maturity extension program—dubbed "Operation Twist" by some—announced by the Federal Open Market Committee last week is designed to further remove longer-term Treasury securities from the market, a move that, other things being equal, should put downward pressure on longer-term rates. Jim Hamilton at Econbrowser has taken a stab at estimating the effects and concludes that it is likely to be modest. Atlanta Fed President Dennis Lockhart shared a similar sentiment, described in more detail later in this posting, in a speech earlier this week.

So what share of outstanding marketable long-term Treasury securities (excluding those held to maturity on government accounts) does the Federal Reserve hold? The following chart shows that the Fed's share of marketable long-term securities with more than five years to maturity increased substantially as a result of the $600 billion asset purchase program between November 2010 and June 2011 (see the chart). This large run-up confirms the point made by Chairman Bernanke that this program removed a considerable supply of longer-term securities from the market (relative to what it would have been otherwise).

(enlarge)

The new maturity extension program will replace $400 billion of shorter-dated Treasury securities that the Fed holds with an equal face-value amount of longer-term securities, and this move will further increase the Fed's relative holdings of marketable longer-term Treasury securities. As President Lockhart noted in his speech, the impact of this program cannot be known precisely, but he expects it to have a modest, positive influence:

"The Fed's maturity extension program and additional mortgage-backed securities purchases are meant to further ease financial conditions ceteris paribus, other things being equal. Of course, other things almost certainly will not stay equal, and other factors will influence what really happens to rates and spreads as policy intent encounters the real world….

"In my view, the maturity extension program along with the MBS purchases represents a measured, incremental attempt to add more support to the recovery. It's not a fix for everything that ails the economy, but it should help."

By John Robertson, vice president and senior economist in the Atlanta Fed's research department

 

What's behind the recent rise in Treasury yields?

David Beckworth, who blogs at Macro and Other Market Musings, posted a comment regarding macroblog's post "What might monetary policy success look like?" from December 2. Beckworth's comment specifically mentioned this chart…

(enlarge)

… as part of this question:

"How did you create the latter figure [shown above]? Using the Fed's own constant maturities series (for both the nominal and real yield), the figure I come up with is less impressive. It shows a turnaround in inflation expectations about the time QE2 is promoted by Fed officials, but then inflation expectations stall and remain far from the 'mandate-consistent inflation rate.'
"Here is a post where I placed one such graph."

And here's the graph of expected inflation from Beckworth's post:

(enlarge)

The series shown in the Beckworth chart has a different economic meaning than the chart shown in the original macroblog post (as was suggested by another commentator to our earlier post).

The chart Beckworth shows in his referenced blog post is the five-year Treasury Inflation-Protected Securities (TIPS) spread (the difference in nominal and real Treasury yields at five-year maturities). And so when he states, "This figure shows average annual expected inflation over the next five years has been flatlining around 1.55% over most of November" it means just that: it's examining the next five-year period (2010–15). I've reposted below an updated version of this chart, along with the 10-year TIPS spread. Since Beckworth's comment on macroblog, the five-year TIPS spread has widened about 13 basis points, depending on the measure you're using.

(enlarge)

The chart used in the December 2 macroblog post is a different measure altogether. It's the five-year/five-year forward break-even inflation rate—not the TIPS spread. This chart shows a measure of expected inflation in the five-year period beginning five years from now. So this chart shows what investors expect to be the cumulative change in the consumer price index beginning in November 2015 through November 2020. Put another way, it's the realized inflation that would provide an equivalent return to both the nominal Treasury securities and the real TIPS securities. An updated picture is provided below.

(enlarge)

Thus we're talking about apples and oranges in two respects: (1) these two charts cover different periods (2010–15 versus 2015–20); and (2) the two calculations themselves are different (taking a simple nominal-real spread versus the 5-year/5-year forward calculation).

Now what's the point of all of this, besides highlighting the minutiae of measuring inflation expectations? Resurrecting Beckworth's question and answering it help illuminate the recent concern about increases in Treasury yields. Indeed, since the November Federal Open Market Committee (FOMC) meeting, longer-dated yields have risen considerably, with the 10-year bond's yield up 86 basis points, for example. But the recent movements in nominal and real yields can be placed in two categories: (A) from when the Federal Reserve began signaling consideration of further asset purchases (late August) to the November FOMC meeting, and (B) the post-November FOMC meeting period. In period A, nominal yields were relatively flat while real yields declined somewhat, indicating a healthy rise in inflation expectations from the lows seen this summer (this change is shown by the increase in the TIPS spreads and breakeven inflation rates during the period).  In period B, the rise in nominal yields has been primarily driven by a rise in real yields (not unanchored inflation expectations).

(enlarge)

As Martin Wolf wrote in Tuesday's Financial Times on this issue, "To understand what is going on, we need to distinguish the role of shifts in real interest rates from that of shifts in inflation expectations." As is evident in the charts, and in one of Beckworth's most recent posts, real rates have risen alongside nominal rates—a sign that inflation expectations are now relatively stable.

By Andrew Flowers, senior economic research analyst in the Atlanta Fed's research department

 

Do we need to rethink macroeconomic policy?

The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:

"Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

"At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further."

Paul Krugman approves, as does Ken Houghton at Angry Bear, who concludes with this comment:

"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."

I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this…

"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."

… which confirms the results of an earlier IMF study:

"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"

To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:

"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "

So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:

"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.

"There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."

Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.

The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?

In fact, Blanchard and company acknowledge that…

"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."

… but follow up with this:

"But it is clear that the zero nominal interest rate bound has proven costly."

Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:

"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)

The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.

Update: Related thoughts, from Mark Thoma and from Caroline Baum.

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

Interest rates at center stage

In case you were just yesterday wondering if interest rates could get any lower, the answer was "yes":

"The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end."

"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. A bit more precisely, the levels of real interest rates are tied to the growth rate of the economy. When growth is slow, rates are low.

The intuition behind this point really is pretty simple. When the economy is struggling along—when consumer spending is muted and businesses' taste for acquiring investment goods is restrained—the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:

"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. However, the net percentages of banks that tightened standards and terms for most loan categories continued to decline from the peaks reached late last year."

Demand also appears to be quite weak:

"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."

This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:

"The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Not everyone is buying my story, of course, and there is a growing global chorus of folk who see a policy mistake at hand:

"Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

"Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.

"Last weekend, Liu Mingkang, China's banking regulator, criticised the US Federal Reserve for fuelling the 'dollar carry-trade', in which investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets abroad."

The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:

But the quantity of bank lending is decidedly not on the rise:

There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?

If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?

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

Us and them: Reviewing central bank actions in the financial crisis

With all the focus on the financial crisis in the United States, folks in this country might sometimes lose sight of the fact that this crisis has been global in nature. To provide some perspective on the global dimensions of the crisis, we are providing a few summary indicators of financial sector performance and central bank policy responses in the United States, the United Kingdom, the Euro Area, and Canada. Based on this general review, we surmise that some of the experiences have been remarkably similar, while others appear to be quite different. To pre-empt the question: Why these four regions? The reason is simply that the data were readily available. We encourage readers to use data from other areas, and let us know what you find.

The first chart compares relative changes in monthly stock market price indices for 2005 through the end of August. During the crisis, market participants significantly reduced their exposure to risky assets, which helped push equities lower. All indices peaked in 2007, except Canada, which technically peaked in May 2008. Canada outperformed relative to the others in early 2008 but suffered proportionally similar losses thereafter. The United Kingdom, Euro Area, and Canada bottomed in February 2009 while the United States bottomed in March 2009. The Euro Area to date has experienced the strongest rebound in equities, increasing by almost 40 percent since the trough in February. However, Europe also had the largest peak-to-trough decline, almost 60 percent. Canada and the United States have jumped by about 33 percent since their respective lows in February and March, while U.K. stock prices have risen by about 30 percent since February.

 

The second chart compares long-term government yields. As the crisis unfolded in late 2007, yields on 10-year U.S. Treasuries sank as global flight to quality helped push yields lower. Yields on U.S., U.K., and Canadian bonds have all moved lower than they were prior to the onset of the crisis. Interestingly, in the Euro Area, prior to the crisis, sovereign yields were at or below bond yields in the other countries but are now slightly above those. In fact, Euro Area yields haven't moved much since the beginning of the crisis in late 2007.

The third chart contrasts monetary policy rates in the four regions. The chart shows that all the central banks lowered rates aggressively, but there are some subtle differences in the timing. For the United Kingdom, Euro Area, and Canada, the bulk of policy rate cuts came after the financial market turmoil accelerated in the fall of 2008, whereas in the United States the majority of the cuts came earlier.

The Fed was the first to lower rates, cutting the fed funds rate by 50 basis points in September 2007 at the onset of the crisis. The Fed continued to lower rates pretty aggressively through April 2008, with a cumulative reduction of 325 basis points. Once the financial turmoil accelerated again in the fall of 2008 the Fed cut rates again by another 200 basis points.

The Bank of Canada's cuts followed a generally similar timing pattern to the Fed but with differences in the relative magnitude of the cuts. In particular, the Bank of Canada rate lowered rates by 150 basis points through April 2008 and then by another 275 basis points since September 2008.

Similarly, the Bank of England cut rates three times in late 2007/early 2008, totaling 75 basis points. But like the Bank of Canada, the bulk of their policy rate cuts didn't come until the increased financial turmoil in the fall of 2008. Between September 2008 and March 2009, the Bank of England cut the policy rate by 450 basis points.

Unlike the other central banks, the European Central Bank (ECB) did not initially adjust policy rates down as the crisis emerged in late 2007. In fact, after holding rates steady for several months it increased its rate from 4 percent to 4.25 percent in July 2008. It started cutting rates in October 2008, and from October 2008 to May 2009 the ECB reduced its refinancing rate by 325 basis points. Of the four regions, the ECB currently has the highest policy rate at 1 percent. For some speculation about the future of monetary policy rates for a broader set of countries, see this recent article from The Economist.

The final chart compares relative changes in the size of balance sheets across the four central banks. The balance sheet changes might be viewed as an indication of the relative aggressiveness of nonstandard policy actions by the central banks, noting that some of the increases can be attributed to quantitative easing monetary policy actions, some to central bank lender-of-last-resort functions, and some to targeted asset purchases.

The sharpest increases in the central bank balance sheets came in the wake of the most intense part of the financial crisis, in the fall of 2008. There had been relatively little balance sheet expansion until the fall 2008. Prior to that, the action was focused mostly on changing the composition of the asset side of the balance sheet rather than increasing its size. The size of both U.S. and U.K. balance sheets has more than doubled since before September 2008, although both are now below their peaks from late 2008. Note that in the case of the Bank of England, quantitative easing didn't begin until March 2009, and the subsequent run-up in the size of the balance sheet is much more significant than in the United States. Prior to that, the increase in the Bank of England balance sheet was associated with (sterilized) expansion of its lending facilities.

In contrast, the Bank of Canada and ECB increased their balance sheets by about 50 percent—much less than in the United Kingdom or United States. By this metric, nonstandard policy actions have been less aggressive in Canada and the Euro Area. Why these differences? This recent Reuters article provides a hypothesis that focuses on institutional differences between the Bank of England and the ECB. In a related piece, this IMF article compares the ECB and the Bank of England nonstandard policy actions.

Note: The Bank of England introduced reforms to its money market operations in May 2006, which changed the way it reports the bank's balance sheet data (see BOE note).

By John Robertson, vice president and senior economist, and Mike Hammill and Courtney Nosal, both economic policy analysts, at the Atlanta Fed

A funny thing happened update

More than a week has passed since the Regulation D changes went into effect, and it appears that the changes are having a noticeable, if not dramatic, impact on pricing in the funds market—see the updated effective funds rate chart below.

The funds rate did fall last week, and it is possible that the softening was related to an increased supply of fed funds by Federal Home Loan Banks as they sought to reduce their excess reserve balances because they no longer earned interest on those balances. But if that is in fact the explanation, the effect was not large: Fed funds are still trading in a relatively narrow range between about 5 and 40 basis points each day. Though, as the chart shows, the effective fed funds rate has drifted lower so far in July—it was at 15 basis points on Friday, July 10, down from 20 basis points on July 1. The current rate is well above the January low of 8 basis points.

Despite the large increase in supply of funds in the market that might have resulted from the Reg D change, it seems to me that the opportunity for arbitrage profits is helping keep the effective funds rate hovering in the neighborhood of the interest rate paid by the Fed to eligible institutions on their reserve balances.

By John Robertson, vice president in research at the Atlanta Fed

A funny thing happened on the way to the federal funds market

Since the beginning of this year, the effective funds rate in the market for reserve balances has varied between zero and about 15 basis points below the interest rate the Federal Reserve pays on those reserve balances (see chart below, which runs through July 2). A vexing issue has been the fact that the interest paid on reserve balances at the Fed has not set a floor on the funds rate traded in the funds market, but rather it has acted more like a magnet (see, for example, this PrefBlog post from early this year).

On July 2, the Federal Reserve Board’s latest amendments to Regulation D (Reserve Requirement of Depository Institutions) went into effect. Included in these changes are two that could materially affect the fed funds market and that vexing gap between the fed funds market rate and the deposit rate.

The first is the authorization for correspondent banks to create Excess Balance Account (EBA) programs on behalf of their respondent financial institution clients. The second is the nullification of an exemption that allowed ineligible institutions (such as the Federal Home Loan Banks) to earn interest on their reserve balances as a result of providing reserve management services for banks.

This change is good news for the 20 or so bankers' banks that provide respondent banks, usually community banks, with services, such as managing the respondent’s reserve balances at the Fed. Prior to the change in Regulation D, a bankers' bank was required to pool all the respondent’s reserve deposits into its own reserve account. This task is a bit of a problem when excess reserves are at high levels because reserves are a bank asset that counts against regulatory capital-to-asset ratios. Partly because of this financial leverage concern, bankers’ banks have had to sell some of their respondent excess reserves into the fed funds market and earn less than the 25 basis points offered for reserve balances at the Fed. But with the change in Reg. D, they will be able to deposit respondent balances at the Fed in the EBAs, and this approach will alleviate their balance sheet pressure.

What does this change mean for the funds market? Well, one source of supply of funds will be reduced, and that should put upward pressure on the fed funds rate. That’s good news for closing the deposit/market rate spread, although it should be said that bankers’ banks represent only a small fraction (about 5 percent) of daily fed funds market activity, so the impact will probably be equally small.

The second change could be a more significant one and will tend to put downward pressure on the effective funds rate. Nine of the 12 Federal Home Loan Banks (FHLBs) provide respondent banking services (like bankers’ banks) for some of their member institutions. These FHLBs had been pooling their own reserve balances with their respondents’ balances, thus earning interest on their own reserves as well. Technically, the FHLBs, like other government-sponsored enterprises, are ineligible to earn interest on their own reserve balances held at the Fed, but the FHLBs were given an exemption under the interim rule published last year, which did not distinguish between an FHLB’s own reserve balances and those of their respondents. With the amended Reg. D, the pooling of reserves will no longer be allowed. Thus, the FHLBs will not be able to earn interest on their own reserve balances.

Will this change matter to them? A look at the FHLB consolidated balance sheet suggests it could. For instance, as of Sept. 30, 2008, the FHLBs were sellers of some $94 billion of fed funds and held zero on deposit at the Fed. But as of Dec. 31, 2008, after the Fed started paying interest on reserves, the FHLBs sold only $40 billion of fed funds and held $47 billion on deposit at the Fed. In a funds market that has been experiencing relatively light volumes in 2009 year to date, the potential additional supply of dollar reserves by the FHLBs could materially affect rates in the fed funds market.

What happened when the regulation changes took effect yesterday? Well, the fed funds effective rate yesterday declined from 20 to 17 basis points. Thus, it appears the softer funding conditions expected as a result of the changes generally failed to materialize. But it still may be too early to determine the full impact of the regulation changes, and more definitive changes in trading could materialize in coming days. Fed funds market nerds stay tuned.

By John Robertson, vice president in research at the Atlanta Fed

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:

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.